The tax bite on your gains and income from mutual funds may be going up—making it even more important to consider how tax-efficient a fund is if you own shares in it or might buy shares. What fund investors should do now…

CHECK TAX EFFICIENCY

In some cases, a fund might be so tax-inefficient that the tax bite will cut way into the fund’s returns. In other cases, a fund is designed or operated in a way that avoids a big tax bite. Of course, even if a fund that you hold in a taxable account is tax-inefficient, you may want to overlook that drawback if the fund’s performance record or some other factors make it especially attractive.

To check on a particular fund’s tax efficiency, search for its “Quote” page at Morningstar.com, then click on the “Tax” tab. On the “Tax Analysis” page, you will see a comparison of the tax-adjusted past returns with the pretax returns and where the fund ranks in its category for tax efficiency over various periods. Compare these after-tax returns with those of other funds that you are considering. Also check the fund’s tax-cost ratio, a measure of how much a fund’s annualized returns have been reduced by the taxes that investors pay on dividend and capital gains distributions. I like to see an average tax-cost ratio of no more than 0.75 for the past decade, which means that if a fund had an annualized pretax return of 10%, a hypothetical investor took home about 9.25% on an after-tax basis. (Morningstar uses the highest income tax rate for calculations.)

To get an estimate of how tax-efficient a fund may be in the future, look at the fund’s potential capital gains exposure on the “Tax Analysis” page. This number represents the percent of the fund’s assets that consist of gains and therefore could trigger the capital gains tax if the shares are sold. But this figure may not be a red flag if the fund tends to have little annual turnover in stocks. Then go back to the fund’s “Quote” page, and check the turnover ratio, a measure of the amount of trading a manager has done in the past year. Funds that trigger little in taxes typically have turnover ratios that are less than 20%.

One of the easiest ways to ensure tax efficiency is to choose an index fund or an exchange-traded fund (ETF) that tracks a particular index. Most of these funds have little turnover in the stocks they hold, so they usually don’t generate much in capital gains distributions. But because the managers typically don’t adjust holdings in these funds based on market conditions, they may not deliver the superior returns offered by the best “active” managers. If you choose funds carefully, you can find actively managed ones that offer both tax efficiency and superior returns. Usually that means that the fund manager is not only a great stock picker but also tends to hold onto stocks for long periods and pays some attention to offsetting gains in some stocks with losses in others.

Attractive tax-efficient funds…

LARGE-CAP FUNDS

Amana Trust Income Fund (AMANX) is one of the best performing and most tax-efficient large-cap mutual funds. Fund manager Nicholas Kaiser buys undervalued companies with good long-term prospects and expects to hold them for many years. The fund has an average annual turnover of just 3%. It receives scant attention because it is marketed to Muslim investors and abides by Islamic values that preclude it from owning stocks in any company that derives more than 5% of its revenue from alcohol, tobacco, pornography, gambling or banking. Nevertheless, anybody can buy shares in the fund, and the majority of investors, including manager Kaiser, are not Muslim. Over the past decade, the fund’s investing constraints have worked to its advantage, allowing Kaiser to sidestep the blowup in financial institutions and companies that rely heavily on debt to finance their operations. Tax-adjusted performance: 11.2%.* www.AmanaFunds.com

Mairs & Power Growth Fund (MPGFX). Manager William Frels has been called the “Maytag repairman” of fund managers, a testament to his patience. The average stock has been in the portfolio for 20 years. Half the companies that Frels invests in are headquartered near his Minnesota offices, including 3M, Toro Co. and Hormel Foods. Concentrating on nearby well-managed companies lets him better monitor their growth and gives him the confidence to stick with them during rough patches. Tax-adjusted performance: 8.3%. www.MairsAndPower.com

Vanguard Dividend Growth Fund (VDIGX). Manager Donald Kilbride searches for companies that are likely to raise dividends by about 10% a year in the next five years. Businesses capable of doing that typically have characteristics that bode well for long-term returns, including low debt, high profit margins and the ability to adapt to any economic environment. Investors have lost only about one-third of a percentage point annually to taxes from the fund’s returns. Tax-adjusted performance: 8.6%. www.Vanguard.com

SMALL-CAP FUND

Gabelli Small Cap Growth AAA Fund (GABSX). Many small-cap funds that focus on businesses with strong prospects for earnings growth engage in rapid-fire trading and generate higher taxes. But veteran manager Mario Gabelli has run this fund for more than 20 years with an average annual turnover of just 14%. He spreads the fund’s assets across nearly 600 stocks…and buys stocks only when they look like bargains. The fund’s 10-year returns land in the top 11% of its category. Tax-adjusted performance: 11%. www.Gabelli.com

FOREIGN FUND

Dodge & Cox International Stock Fund (DODFX). This fund invests in out-of-favor large-caps such as European drugmakers Novartis and Roche Holding, then patiently holds them for an average of six to seven years. That’s more than twice the holding period of the average foreign large-cap value fund. The fund’s buy-and-hold approach has paid off over time, ranking it in the top 3% of its category over the past decade. Tax-adjusted performance: 11%. www.DodgeAndCox.com

*Fund performance figures are tax-adjusted annualized returns for the 10 years through September 30, 2012.

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