DEFINITION of 'Tax-Efficient Fund'

A mutual fund in which structure and operations are based on reducing the tax liability that its shareholders face. 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.

BREAKING DOWN 'Tax-Efficient Fund'

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.

To determine how much you will save in this type of fund compared to other funds, review the investment company's and/or mutual fund's tracking services for statistics regarding a fund's historic tax costs.

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