Tired of Taxes? Look for Tax-Friendly Funds

Many investors are surprised that they owe taxes on income and gains realized by funds they own. After all, they reason, they haven't received any checks. By law, however, funds must distribute their income and gains to shareholders. And somebody (read: the investor) has to foot the tax bill.

The surefire way to avoid taxes, of course, is to keep your funds in a tax-deferred account. If you do hold funds in taxable accounts, however, you should look for tax-efficient funds in order to minimize your tax bill.

One of the best ways to find tax-friendly funds, says Christine Benz, Morningstar's director of mutual fund analysis, is to look for "tax-managed" in the fund's name. Managers of tax-managed funds try to minimize shareholders' tax burdens by offsetting capital gains with capital losses in the portfolio and avoiding investments that generate ordinary income.

Morningstar Library Edition provides a quick and easy way for users to analyze a fund's tax efficiency. Look up any mutual fund report in Morningstar and click on the Tax Analysis tab in the left-hand column.

Here you'll see returns before and after taxes. You'll also see how the fund's before-tax and after-tax returns stack up against the rest of its category. Further, the Tax Cost Ratio measures how much a fund's annualized return is reduced by the taxes investors pay on distributions. For example, if a fund had a 2% Tax Cost Ratio for the three-year time period, it means that on average each year, investors in that fund lost 2% of their assets to taxes. A score of 0% represents the most tax-efficient funds, and 5% the worst.

An even easier way to find tax-efficient funds is to use the preset screen already in Morningstar Library Edition. Just click here to log in to Morningstar. (Provide your library card barcode number and PIN.) Select Screeners, then click on the white box labeled "Morningstar Screens." Open the "Select Screen" box at the top. Select "Aftertax Stars." It's that simple. So, whenever you find yourself grumbling about taxes, just know that you can use Morningstar Library Edition to find funds that won't tax your wallet.

If you would like more information about how you can access Morningstar, please click here or call the Library at 826-3712.