Every April, I try to remind myself that paying taxes is a good thing. First off, it means I’ve made money. It’s also how I contribute to the projects that support the community and society I live in.
Nonetheless, when I put my investor hat on, taxes are a cost. And Vanguard founder Jack Bogle wasn’t wrong when he said, “In investing, you get what you don’t pay for.” So, while it’s generally good practice to try and keep your tax bill down, I think many investors go too far and confuse minimizing their tax bill with maximizing their after-tax returns.
Some investors obsess over taxes instead of their after-tax bottom line because taxes are easier to track (and painful to pay). We are handed a tax bill at least once a year—typically in April—but our after-tax mutual fund or ETF returns? Well, those are rarely shown to us in black and white.
For years, Dan and I tried to bring after-tax returns (and tax efficiency) out of the shadows, and I will continue to do so. This year, I enhanced the way I track and calculate after-tax returns to enable me to explore the topic in greater detail and better answer questions like:
- Does tax efficiency change over time?
- Are low-turnover funds more tax efficient?
- Can active funds outperform index funds after taxes?
- From a tax standpoint, are ETFs superior to index funds?
The tax efficiency topic is a big one, and I’m not going to try and answer those questions today—each is deserving of its own comprehensive focus, so stay tuned. To set the stage for more exploration into tax efficiency, let’s start at the beginning by defining some key terms and taking a snapshot of Vanguard’s funds from that perspective.
Which After Tax Returns?
The mutual fund and ETF returns you see, well, pretty much everywhere—from Vanguard’s website to Morningstar to our Performance Review tables—are calculated without regard for taxes. This is generally the “right way” to view fund returns. Not only do many investors hold funds in tax-deferred accounts, where taxes aren’t an issue, but each individual’s tax situation is unique.
That said, not all investments are held in tax-deferred accounts. And even if you aren’t selling, mutual funds and ETFs pay out distributions at least annually, which you’ll owe taxes on. This means that there is also merit to looking at returns after the IRS has taken its cut.
As I see it, there are two levels of after-tax returns to look at: The first is your return after taxes on distributions. To calculate this return, you have to apply a haircut to the dividend, interest and capital gain distributions paid out by a fund even if you are reinvesting.
The second level is your return after taxes on distributions and the sale of the fund. This step involves accounting for the tax bill generated by the distributions and what you would owe if you sold your shares.
I see arguments for and against making this additional calculation, but to keep things simple—particularly for investors like us, who take a long-term perspective and aren’t selling shares every year—I’m going to keep my analysis focused on the first calculation, returns after taxes on distributions.
So, when I talk about after-tax returns, I’m adjusting for the taxes on a fund’s distributions, but I’m assuming you continue to hold your shares. To that end, in the analysis that follows, I applied a 20% tax rate to qualified income (such as dividends) and long-term capital gains and a 43.4% tax rate to short-term capital gains and regular income such as interest. (For simplicity’s sake, I’ve left state and local taxes aside.) Finally, all of my calculations are as of March 2023.
Once we have our before-tax and after-tax returns, we can calculate a fund’s tax efficiency—the percentage of a fund’s returns that you keep after you’ve paid the tax man. As an example, Wellington (VWELX) earned an 8.0% annualized return over the 10 years ending in March, but, after taxes, an investor earned 6.3%—giving the fund a tax efficiency of 78%. Investors gave up one-fifth of the fund’s gross returns to taxes over the decade.
You might wonder why mutual funds and ETFs pay out distributions, saddling ongoing shareholders with a tax bill. In short, it’s the law. At least once a year, mutual funds and ETFs must pay out the interest and dividends they’ve received plus any capital gains they have realized to all shareholders.
Dividends and interest are easy. If a stock pays a dividend, the mutual fund passes that dividend on to shareholders. If a bond pays interest, that interest gets passed along as well.
Realized capital gains are the net trading profits the fund generated during the year and are a little trickier to understand.
Every fund, even index funds, engages in at least a little trading activity over the course of the year. That trading may come from an active portfolio manager buying a new stock or bond or selling an existing position. Or the trading could occur as companies are added to or taken out of one index or another and the index fund manager must continue tracking that index. If Vanguard hires and fires the sub-advisers of a fund, you can bet that will lead to a lot of trading. And, of course, some trading is the result of us shareholders—when we add or withdraw money from a fund, the managers have to act, and if they don’t have enough cash on hand to meet redemptions, well, they sell something.
Whatever the cause of the trading within the fund, when a position is sold, it is either sold at a profit or a loss. When the fund tallies up those trades near the end of the year, if the profits outweigh the losses from all of those sales, then the net realized “capital gains” must be distributed to shareholders.
This link between trading and taxes leads some investors to assume that funds reporting low turnover rates must be more tax efficient. I’ll explore this in a future article, but (spoiler alert) it’s not always the case; there are much better indicators of a fund’s tax efficiency than turnover.
Cost Basis Confusion
While we are talking performance numbers and taxes, let me quickly offer a word of caution when it comes to judging your fund’s performance using the cost basis you see reported on your account statements. Don’t do it. If your fund has paid any distributions, then comparing your current position value to its cost basis will not reflect your actual performance.
I know that sounds counterintuitive. So, let’s walk through at an example.
Say you invested $10,000 in High-Yield Corporate (VWEHX) when it was trading at $5.26 per share at the end of March 2020. If you reinvested distributions, your position would be worth $11,456 at the end of March 2022. You put in $10,000 and now have $11,456—I think we can all agree that you’ve made money on that investment, a gain of 15%.