For mutual fund investors, sharing less with Uncle Sam is a little trickier because a lot of portfolio managers aren't concerned about taxes. Their shareholders may be endowments and foundations, which pay few taxes, or individuals who invest through tax-deferred IRAs and 401(k) plans.
In addition, a manager's strategy may require frequent buying and selling of shares. Any capital gains from those transactions that can't be offset with losses have to be passed on to shareholders, who must then suffer the tax consequences.
A fund full of growth stocks should, in theory, be fairly tax-efficient, particularly if the manager is careful to match sales of winners with sales of losers to offset potential taxable gains. For example, T. Rowe Price Science and Technology (PRSCX; 800-638-5660) hasn't made a taxable distribution in eight years because it has been able to use substantial losses suffered from 2000 to 2002 to offset subsequent gains.
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But value funds, too, can come with a tiny tax bill if the manager uses a low-turnover strategy. Taxable distributions by Kiplinger 25 member Selected American Shares (SLASX; 800-243-1575) have historically been minuscule.
The best choices for tax-conscious investors are index funds. That's because they track relatively stable portfolios that seldom change. Fewer transactions translate into few taxable gains.
For extra tax protection, consider a tax-managed fund. These are funds that explicitly promise to take taxes into account when managing the portfolio.
For example, Michael Buek, manager of the Vanguard Tax-Managed Capital Appreciation fund (VMCAX; 800-635-1511), buys low-dividend stocks from the Russell 1000 index, holds them a long time and carefully matches investment gains and losses. The 13-year-old fund has never made a capital-gains distribution while managing to beat the return of its benchmark over the past five- and ten-year periods.
Benefitting from careful management
Tax-efficient funds strive to minimize distributions by trading infrequently and by matching losses with gains. Vanguard Tax-Managed Growth & Income, for example, returned less than the average large-blend fund over the past five and ten years.
But after taxes on distributions are taken into account, you end up with more in the Vanguard fund. Note, however, that you lose some of the advantages of tax efficiency once you sell your fund and pay taxes on your gains.
| Row 0 - Cell 0 | Row 0 - Cell 1 | Length of holding period | |
| Fund | Row 1 - Cell 1 | 5 years | 10 years |
| Vanguard Tax-Managed Growth & Income | Growth of $10,000 before taxes | $18,221 | $17,756 |
| Row 3 - Cell 0 | After-tax value before liquidation | 17,956 | 17,087 |
| Average Large-Blend Fund | Growth of $10,000 before taxes | 18,231 | 18,158 |
| Row 5 - Cell 0 | After-tax value before liquidation | 17,388 | 16,137 |
| How much more the tax-managed fund is worth | $568 | $950 |
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