It’s not what you earn before taxes, but what you have left after taxes that counts. Most investors are well in tune with this principle when comparing a taxable corporate bond yielding 6% to a tax-free municipal bond yielding 4%. When the federal and state tax rate on that corporate bond exceeds about 33%, the investor has more after-tax cash flow by investing in the double-exempt municipal bond.
But what about mutual funds, with their confusing mix of dividends, ordinary income and capital gain distributions?
For several years now, mutual funds have been under a requirement to disclose not only pre-tax yields, but an important measure of after-tax performance in their prospectus. For investors with a buy-and-hold philosophy, the “return after taxes on distributions” is the key statistic. This return reflects the impact of sales charges and income taxes on both current income and capital gain distributions. The fund is required to assume that the taxes are incurred at the top ordinary income and capital gain rates in measuring this rate of return.
Illustration
To understand the impact that taxes and charge sales can have on investments, here is a quick example. Assume that you are considering two mutual funds, both with advertised 10 year pre-tax returns of 13.5%. But digging deeper, you find that Fund A has an after-tax performance of 12%, while Fund B has a 9% after-tax return. If you invest $10,000 and the same yields hold true for 10 years, an investment in Fund B would return about $23,700, whereas the more-efficient Fund A would yield about $31,000. This is over a $7,000 difference on a $10,000 investment held for only 10 years!
On occasion, clients request that we determine their rate of return on various types of investments [fully taxable, fully exempt, and exempt from either federal tax (e.g., a municipal bond from a different state) or exempt from state tax (a U.S. Treasury security)]. Using our tax software with your particular income and deduction data, we can determine the effective after-tax yield of each category of investment. Please let us know if we can be of assistance.
