By this time, most mutual funds have closed the books on their fiscal years and are busy calculating the income and capital gains realized over the last 12 months--taxable events that pop up in November and December as a sort of pre-holiday surprise to fund shareholders.
This year's volatile stock market and the intense anxiety among active fund managers to beat no-brainer stock index returns may have led many funds to churn their holdings in a search for presentable short-term returns.
In addition, persistent cash redemptions by many fund shareholders have forced fund managers to sell winning securities with sizable capital gains, despite their intended strategy of buying and holding investments.
These circumstances, plus the inevitable demographic trend of Americans retiring out of tax-deferred investment plans and into taxable investment accounts, finally are bringing the tax consequences of mutual fund investing to the front burner.
Unfortunately, the appealing notion of a "tax-efficient" mutual fund is complex and can easily be distorted, said Joel Dickson, a principal and tax expert at fund powerhouse Vanguard Group.
Vanguard said recently that it would begin reporting after-tax returns in the annual reports for 47 of its equity and balanced (equity and debt) funds. Vanguard is the first major fund group to take this step.
Vanguard considers minimizing taxable income, like minimizing fund expenses, an important task of a fund manager.
"There is a long history of Vanguard talking about what we think is most important in determining long-run returns, and that is cost," Dickson said, adding that Vanguard considers minimizing taxable income a major element of cost control.
Dickson said there are about 30 factors that determine what kind of taxes a fund shareholder with a taxable account will face from year to year in owning a mutual fund.
"The most important ones would be [portfolio] turnover, net cash flow and the objective of the fund," he said. But the larger problem, he asserted, is that "no one cares about taxes in the management of a portfolio."
Portfolio turnover--how much of the fund's assets are sold during the year--seems an obvious culprit in exposing fund shareholders to taxes. A security sold by a fund manager at a gain can create taxable income that is passed on to fund shareholders, even though shareholders have no plans to sell their fund shares.
Many fund groups have introduced funds they advertise as being tax managed or tax efficient, focusing on low portfolio turnover. But lower turnover does not guarantee lower taxes and certainly is no key to better after-tax returns, Dickson said.
"I chuckle every time I see a new tax-managed fund that comes out and says, 'We're going to employ a low-turnover, buy-and-hold strategy,' " he said. "Why would I pay an active-management price for an index fund?"
Tax results among actively managed funds vary widely. For example, Vanguard's Windsor Fund over the years has posted relatively low annual turnover--about 45 percent of assets, far below the 100 percent or more at many funds--but Windsor cannot be termed tax efficient relative to its peers.
"It has a consistent pattern of buying low and selling high," Dickson said. "It doesn't sell its losers" and therefore lacks investment losses against which to offset taxable gains.
On the other hand, Vanguard's actively managed U.S. Growth Fund has been more tax efficient over the last 10 years than even Vanguard's flagship Index 500 Trust, which tracks the Standard & Poor's 500-stock index.
"The U.S. Growth Fund has much higher turnover than our index fund, but at the beginning of this [10-year] period, it had a lot of capital-loss carryforwards coming out of the 1987 stock market crash, so it was able to offset a ton of gains," Dickson said.
One of the perverse effects of taxes is that funds with low expenses, such as Vanguard's family of funds, could end up exposing shareholders to higher taxes than funds with high expenses.
Why? Because a fund's expenses are deducted from the dividends it passes on to shareholders. Higher expenses lower the net dividend distribution. Of course, no mutual fund shareholder would want the fund to jack up expenses just to lower net dividend payouts.
The bottom line of tax effects in a mutual fund is that they can be managed. "The tax code, as terrible as it is to slog through, is at least known," Dickson said. "You know the rules and you know how to manage around the rules, as opposed to what the pretax return is going to be on the stock market over the next 10 years. It's a cost that is controllable."
Vanguard, like most analysts of tax effects in fund investing, uses the top marginal tax rate of 39.6 percent to calculate effects.
Although that rate may be higher than most investors pay, it presents the most conservative data for comparing funds.
For example, over 10 years, the annual pretax total return of large-company growth funds tracked by research firm Morningstar Inc. was 16.1 percent. The after-tax return using the maximum tax rate was 13.6 percent, according to Vanguard's analysis.