Introduction to Tax-Managed Mutual Funds

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Introduction to Tax-Managed Mutual Funds

Tax forms with charts and calculator
One of the chief disadvantages that many mutual funds pose for their shareholders is their annual distribution of long- and short-term capital gains. Fund critics are quick to point out that shareholders who purchase actively managed funds during the last months of the year often receive tax bills for buy and sell transactions that were placed before they invested.
Brokers are typically warned to be careful not to sell funds that do this during the month of November, as this is usually when those gains are posted to be passed through to shareholders for the year. Tax-managed mutual funds were therefore introduced to serve investors seeking long-term growth who wanted to avoid this dilemma.

Be sure to also see the 25 Tips Every Mutual Fund Investor Should Know.

How Tax-Managed Mutual Funds Work

Actively managed mutual funds that are tax-managed usually accomplish this element of their objective in two ways. Most of these funds eschew buying stocks that pay dividends, such as large blue-chip corporations, utility offerings and preferred issues. They will instead seek to find quality growth picks that reinvest the vast majority of profits back into the company instead of distributing them to shareholders, and then hold them for long periods of time.

Fund managers will also carefully time their buy and sell transactions to minimize capital gains, and in most cases will hold any security they purchase for at least a year in order to assure long-term capital gains treatment. These funds can hold either domestic or foreign issues and may buy small-, mid- or large-cap companies as long as their dividend distributions are minimal. They may even hold bonds that don’t pay reportable interest to investors in some cases.

It is important to note that while these funds are designed for maximum tax efficiency, they are not always going to be completely tax-free for investors. Shareholders should not be surprised if they receive a 1099-B or 1099-DIV from these funds, but they can probably expect the numbers on these forms to be considerably lower than what they would see from other standard growth funds. However, most tax-managed funds have had many years when no recognizable income of any kind was reported.

Of course, many investors who seek tax-managed growth have looked to other types of vehicles, such as index funds, as they typically offer long-term growth with little or no turnover. The new breed of exchange-traded funds that has appeared in recent years also usually boasts minimal capital gains distributions, but the temptation to trade these instead of holding them for the long term may undermine the investor’s objective in many cases. Municipal bond funds also provide tax-free interest for investors who seek current income.

Be sure to see the 7 Essential Tax Tips for Mutual Fund Investors.

How Should These Funds Be Used?

Tax-managed funds will usually provide the best possible return for investors in the upper tax brackets who have maxed out their retirement savings contributions and are seeking additional tax-advantaged growth outside of their IRAs or other tax-deferred retirement plans.

The tax efficiency of these funds is largely neutralized in these accounts because all income that is distributed from traditional tax-deferred vehicles is taxed as ordinary income regardless of whether it would otherwise qualify for capital gains treatment. Even Roth IRAs are not the best place for these funds, as those distributions are always tax-free (or taxed as ordinary income along with a penalty in the event of early withdrawal).

Most investors who purchase these funds will therefore hold them in taxable retail accounts because of their limited tax liability. Even investors in the bottom tax bracket can benefit from these funds, because the long-term capital gains rate is zero percent for investors in the 15 percent bracket.

See also the 30 Blogs that Mutual Fund Investors Should Read.

Examples of Tax-Managed Funds

Open-ended tax-managed funds are available in both load and no-load form, and many fund companies provide at least one of these types of funds in their family of offerings. Here is a quick breakdown of a few of the more established and well-known tax-managed funds available to investors today.

Vanguard Tax-Managed Small Cap Fund Admiral Shares (VTMSX) – Established in March of 1999, this fund seeks to provide long-term growth by investing in the Standard & Poor’s Small Cap 600 Index. It is appropriate for aggressive investors in higher tax brackets who have a time horizon of at least 5 years. It has posted an average annual return of just over 10% since inception, and $10,000 placed in the fund would have grown to about $25,000 by 2014.

Vanguard Tax-Managed Capital Appreciation Fund Admiral Shares (VTCLX) – This fund focuses on the mid- and large-cap segment of stocks and was incepted in September of 1994. It tracks the Russell 1000 Index and has slightly lower risk than its small-cap cousin. It has posted an average annual total return of about 9.5% since inception, and $10,000 invested in the fund would have grown to about $24,000 by 2014.

Eaton Vance Tax-Managed Growth Fund 1.1 (ETTGX) – This fund invests primarily in core blue-chip stocks that are managed on a tax-efficient basis. It was first introduced in March of 1966 and is one of the oldest tax-managed mutual funds in existence. Its 10-year average annual return after taxes and the maximum 5.75% sales charge is about 6.75% since 2004.

The Bottom Line

Although index and exchange-traded funds as well as those that invest in municipal securities can provide tax-free or tax-efficient returns, many open-ended fund companies also provide competitive offerings in this area.

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Tax forms with charts and calculator

Introduction to Tax-Managed Mutual Funds

One of the chief disadvantages that many mutual funds pose for their shareholders is their annual distribution of long- and short-term capital gains. Fund critics are quick to point out that shareholders who purchase actively managed funds during the last months of the year often receive tax bills for buy and sell transactions that were placed before they invested.
Brokers are typically warned to be careful not to sell funds that do this during the month of November, as this is usually when those gains are posted to be passed through to shareholders for the year. Tax-managed mutual funds were therefore introduced to serve investors seeking long-term growth who wanted to avoid this dilemma.

Be sure to also see the 25 Tips Every Mutual Fund Investor Should Know.

How Tax-Managed Mutual Funds Work

Actively managed mutual funds that are tax-managed usually accomplish this element of their objective in two ways. Most of these funds eschew buying stocks that pay dividends, such as large blue-chip corporations, utility offerings and preferred issues. They will instead seek to find quality growth picks that reinvest the vast majority of profits back into the company instead of distributing them to shareholders, and then hold them for long periods of time.

Fund managers will also carefully time their buy and sell transactions to minimize capital gains, and in most cases will hold any security they purchase for at least a year in order to assure long-term capital gains treatment. These funds can hold either domestic or foreign issues and may buy small-, mid- or large-cap companies as long as their dividend distributions are minimal. They may even hold bonds that don’t pay reportable interest to investors in some cases.

It is important to note that while these funds are designed for maximum tax efficiency, they are not always going to be completely tax-free for investors. Shareholders should not be surprised if they receive a 1099-B or 1099-DIV from these funds, but they can probably expect the numbers on these forms to be considerably lower than what they would see from other standard growth funds. However, most tax-managed funds have had many years when no recognizable income of any kind was reported.

Of course, many investors who seek tax-managed growth have looked to other types of vehicles, such as index funds, as they typically offer long-term growth with little or no turnover. The new breed of exchange-traded funds that has appeared in recent years also usually boasts minimal capital gains distributions, but the temptation to trade these instead of holding them for the long term may undermine the investor’s objective in many cases. Municipal bond funds also provide tax-free interest for investors who seek current income.

Be sure to see the 7 Essential Tax Tips for Mutual Fund Investors.

How Should These Funds Be Used?

Tax-managed funds will usually provide the best possible return for investors in the upper tax brackets who have maxed out their retirement savings contributions and are seeking additional tax-advantaged growth outside of their IRAs or other tax-deferred retirement plans.

The tax efficiency of these funds is largely neutralized in these accounts because all income that is distributed from traditional tax-deferred vehicles is taxed as ordinary income regardless of whether it would otherwise qualify for capital gains treatment. Even Roth IRAs are not the best place for these funds, as those distributions are always tax-free (or taxed as ordinary income along with a penalty in the event of early withdrawal).

Most investors who purchase these funds will therefore hold them in taxable retail accounts because of their limited tax liability. Even investors in the bottom tax bracket can benefit from these funds, because the long-term capital gains rate is zero percent for investors in the 15 percent bracket.

See also the 30 Blogs that Mutual Fund Investors Should Read.

Examples of Tax-Managed Funds

Open-ended tax-managed funds are available in both load and no-load form, and many fund companies provide at least one of these types of funds in their family of offerings. Here is a quick breakdown of a few of the more established and well-known tax-managed funds available to investors today.

Vanguard Tax-Managed Small Cap Fund Admiral Shares (VTMSX) – Established in March of 1999, this fund seeks to provide long-term growth by investing in the Standard & Poor’s Small Cap 600 Index. It is appropriate for aggressive investors in higher tax brackets who have a time horizon of at least 5 years. It has posted an average annual return of just over 10% since inception, and $10,000 placed in the fund would have grown to about $25,000 by 2014.

Vanguard Tax-Managed Capital Appreciation Fund Admiral Shares (VTCLX) – This fund focuses on the mid- and large-cap segment of stocks and was incepted in September of 1994. It tracks the Russell 1000 Index and has slightly lower risk than its small-cap cousin. It has posted an average annual total return of about 9.5% since inception, and $10,000 invested in the fund would have grown to about $24,000 by 2014.

Eaton Vance Tax-Managed Growth Fund 1.1 (ETTGX) – This fund invests primarily in core blue-chip stocks that are managed on a tax-efficient basis. It was first introduced in March of 1966 and is one of the oldest tax-managed mutual funds in existence. Its 10-year average annual return after taxes and the maximum 5.75% sales charge is about 6.75% since 2004.

The Bottom Line

Although index and exchange-traded funds as well as those that invest in municipal securities can provide tax-free or tax-efficient returns, many open-ended fund companies also provide competitive offerings in this area.

If you’ve enjoyed this article, sign up for the free MutualFunds.com newsletter; we’ll send you similar content weekly.


Sign up for Advisor Access

Receive email updates about best performers, news, CE accredited webcasts and more.

Popular Articles

Download our free report

Find out why $30 trillon is invested in mutual funds.

Why 30 trillion is invested in mutual funds book

Why 30 trillion is invested in mutual funds book

Download our free report

Find out why $30 trillon is invested in mutual funds.

Why 30 trillion is invested in mutual funds book

Download our free report

Find out why $30 trillon is invested in mutual funds.


Read Next

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