Repeat after me: Paying taxes is a good thing. Not only does it mean you’ve made money, but it’s also how we contribute to the projects that support the community and society in which we live.
Nonetheless, from an investment standpoint, taxes are a cost. While it’s generally good practice to try to 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 fund returns? Well, those are rarely shown to us in black and white.
As I do every year, I’ll try to bring after-tax returns (and tax efficiency) out of the shadows. I’ll start by defining key terms and taking a snapshot of Vanguard funds’ after-tax returns. In a subsequent article, I’ll compare Vanguard’s exchange-traded funds (ETFs) and index mutual funds.
From that point, well, tax efficiency is a big topic, and there are several directions I could take the conversation. Last year, I taught you how to avoid tax bombs and discussed whether active funds could outperform index funds after taxes. Those are both valuable topics, and I’m sure I’ll revisit them again, but for this year, I will let them stand. I encourage you to give them a read.
Instead, this year, I will analyze how Vanguard’s tax-exempt bond funds stack up to their taxable siblings after taxes. I’m also working on an article comparing Vanguard’s active ETFs to their mutual fund cousins. Stay tuned.
With that said, let’s start at the beginning.
Which After-Tax Returns?
The mutual fund and ETF returns you see 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. Since you’ll owe taxes on those payouts, there is also merit to looking at returns after the IRS has taken its cut.
There are two levels of after-tax returns to consider:
The first is your return after taxes on distributions. To calculate this return, you must 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 will 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.
In the following analysis, I applied a 20% tax rate to qualified income (such as dividends) and long-term capital gains. I used a 43.4% tax rate for short-term capital gains and regular income such as interest. (For simplicity’s sake, I’ve omitted state and local taxes.) Finally, all of my calculations are as of March 2024.
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 you keep after you’ve paid the tax man.
For example, Windsor (VWNDX) earned a 10.0% annualized return over the ten years ending in March, but after taxes, an investor earned 8.0%—giving the fund a tax efficiency of 80%. 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.
Mutual funds and ETFs must pay out the interest and dividends they’ve received at least once a year. They must also pay out any net trading profits (capital gains) they realized to all shareholders. And, remember, every fund, even index funds, engages in at least a little trading activity over the course of the year.
Mutual funds and ETFs are on equal footing when it comes to dividends and interest. While ETFs (broadly speaking) have an advantage regarding capital gains, I’ll explain in a future article why this isn’t the case when discussing Vanguard’s index mutual funds.
A Moment in Time
Let’s return to tax efficiency and look at Vanguard’s funds and ETFs.