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Cut your tax burden with a new breed of mutual funds

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in Small Business Tax

If you’re a high-end taxpayer with a low tolerance for tax pain, you’d be wise to check out a new mutual fund product from Wall Street.

Unlike the stodgy funds of the past, this new breed of tax-efficient funds (also called tax-managed funds) is designed to
provide a steady stream of current income that also produces a favorable after-tax rate.

The scoop: Most mutual funds distribute dividends and capital gains to shareholders on an annual basis. Assuming the funds are held outside of a retirement plan or IRA, you must pay tax on the distributions, even if the funds are automatically reinvested.

Mutual funds typically aren’t concerned with the tax consequences to investors. In contrast, tax-managed funds take tax repercussions into account, mainly by emphasizing capital appreciation.

Now, more tax-managed funds are starting to focus on paying dividend income, as well. This approach makes sense because dividends are now generally taxed at a maximum federal rate of 15 percent.

Some tax-efficient funds also include tax-free municipal bonds in their portfolio. Interest from munis is exempt from federal income tax, giving these funds an extra tax boost.

The rates of returns for tax-efficient funds are typically on a par with traditional mutual funds. But when you compare the after-tax returns, tax-efficient funds have an edge, especially if you’re in a higher bracket.

You’ll find all the important info on tax-managed funds in the offering prospectus. Focus on the after-tax return for your personal tax bracket.
Final tip: Tax-efficient funds aren’t for everyone, but their popularity is growing fast. The Wall Street Journal reports that more than $1 billion flowed into these funds during the last 10 months of 2005.

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