What is a Tax-Efficient Fund?

A tax-efficient fund is a mutual fund or ETF that minimizes the fundholder's tax bill in some way.

How Does a Tax-Efficient Fund Work?

For example, let's say John is in a high tax bracket. He wants to invest, but he wants to avoid a huge tax bill as well.

John looks for a tax-efficient funds to invest in. The managers of tax-efficient funds strategically invest their customers' assets so that large tax liabilities are not created. For example, the fund manager might:

  • Purchase tax-exempt municipal bonds that make interest payments free from federal, state, and/or local taxes;
  • Minimize trading of stocks in order to minimize capital gains taxes (note that most index funds are classified as 'tax-efficient' for that reason; that is, they are buy-and-hold or passive investment strategies);
  • Invest in stocks that do not pay dividends, so as to avoid dividend taxes.

Why Does a Tax-Efficient Fund Matter?

In the investing world, tax efficiency is a big deal. In some cases, the length of time an investment is held can make a difference in a portfolio's tax efficiency. In other cases, certain investments (such as municipal bonds) are simply not subject to certain taxes, making them tax efficient as well. In general, tax efficiency is as much a matter of strategy as it is a matter of tax brackets.

Investors in high tax brackets are often more interested in tax-efficient investing because the potential savings are more significant. However, every investor's portfolio should be as tax efficient as possible. Not only do taxes lower an investor's returns by reducing the amount of cash he or she has to reinvest, but they can also create considerable liquidity barriers for investors who might face huge tax penalties for accessing their own money at the wrong time.

Many investment advisors tell beginning investors to 'max out' every tax-advantaged investing opportunity first, and invest in taxable funds last. Tax-efficient funds are an especially good option for investors who do not have access or are not eligible to own tax-deferred accounts like as Roth IRAs or 401(k)s.