What Is a Tax-Efficient Fund?
A tax-efficient fund is a mutual fund structured to reduce tax liability. In a tax-efficient fund, the structure and operations of the fund are designed to reduce the tax liability that its shareholders face.
How a Tax-Efficient Fund Works
Because tax-efficient funds have a low tax liability, they are often good investments to make outside of a tax-deferred account. This is because there is a minimal amount of tax to be deferred, and the space in an investor's tax-deferred account is better suited for higher taxed securities, such as dividend-paying stocks.
Reducing the tax liability of a fund is done in three main ways:
1. By purchasing tax-free (or low taxed) investments such as municipal bonds.
2. Keeping the fund's turnover low, especially if the fund invests in stock. Stocks held for more than one year are taxed at a lower long-term capital gains rate than short-term transactions.
3. Avoiding or limiting income-generating assets, such as dividend-paying stocks, which create a tax liability at each dividend issuance.
To determine how much you will save in this type of fund compared with other funds, review the investment company's and/or mutual fund's tracking services for statistics regarding a fund's historic tax costs.
Example of a Tax-Efficient Fund
The T. Rowe Price Tax-Efficient Equity Fund pursues the significant return potential of stocks while seeking to reduce the long-term tax burden by investing in a broad range of equities—from mid- and small caps whose futures appear especially promising, to large companies operating in dynamic industries. In short, it invests in growing firms whose management teams, product lines and balance sheets—among other measures—bode well for their future prospects.
In an effort to achieve strong after-tax returns, the fund seeks to avoid realizing capital gain distributions by limiting sales of existing holdings and not rotating from one sector to another in an attempt to capture short-term outperformance. However, taxable gains may be realized in order to satisfy redemption requests or when they believe the benefits of continuing to hold a security outweighs tax considerations. As appropriate, they may attempt to use losses from sales of securities that have declined to offset future gains that would otherwise be taxable.
The T. Rowe Price Tax Efficient Fund’s top 10 holdings, as of December 2021, were:
- Meta Platforms
- UnitedHealth Group
These 10 holdings represented 30.60% of the total fund. The fund had a 10-year annualized return of 18.04%.