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Mutual Funds and Taxes

Some people base their choice of a mutual fund on advertised returns, which usually don't take taxes into account. But this strategy can backfire. A fund pays out some or all of its earnings and profits to shareholders in the form of distributions. You must pay taxes on those distributions, reducing the advertised return to an after-tax return that will vary, depending on your tax bracket. For example, let's assume that you owned shares in a fund with a total pretax return of 10%. If you gave up 3% to taxes, you'd get to keep only 70% of your fund's gains. Taxable stock fund investors surrendered 2% to 3% to federal taxes each year through the 1990s, according to Morningstar, Inc.

The following chart illustrates what most newspaper mutual fund advertisements don't tell you. It looks at the after-tax results for investors in three tax brackets. Each is invested in the same three funds, but each sees different results.

The Effect of Taxes on Returns

  Advertised Pretax Return Investor A After-Tax Return (15% bracket) Investor B After-Tax Return (28% bracket) Investor C After-Tax Return (39.6% bracket)
Stock Fund * 10% 9.20% 8.48% 8.41%
Long-Term Bond Fund 7% 5.95% 5.04% 4.23%
Money Market Fund 4% 3.40% 2.88% 2.42%

*Assumes 8% capital return and 2% income return. One-half of capital return is unrealized. The realized gain is split equally between short-term and long-term gains. The returns for bond and money market funds are assumed to be 100% income return. This example is for illustrative purposes only and does not imply returns available on any particular investment.

Translate the above into dollars and cents and it becomes even clearer. All three investors made the same decision a decade ago: Each invested $15,000, split evenly between the three funds. When the time came to redeem the accounts, Investor A had $27,953, Investor B had $26,101, and Investor C had $25,127.

As you can see, a fund's advertised return can look a lot different from your after-tax return, depending on your tax bracket.


Steven Huddart
Smeal College of Business, Penn State University, University Park, PA 16802-3603 USA
(814) 863-0048
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was last updated on Tue, Aug 21, 2018.
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