Tax Efficiency vs. After-Tax Returns

Let’s talk about taxes.

I’ve said it for years: It isn’t tax efficiency that investors should strive for, it’s after-tax returns. That is: What you keep once you pay the tax man.

So, which funds give you the best after-tax returns? And are they necessarily the most tax-efficient? Finally, with so many "tax-managed" funds on the market, are any worth your investment dollars?

Every year, I analyze the three-year and five-year tax-adjusted returns for all Vanguard funds (see “10 Things Vanguard Won’t Tell You“). I also go one step further and, besides using the current income and capital gains tax rates in my calculations, I incorporate reduced tax rates on qualified dividend income as specified under the 2003 Tax Act.

I don’t think it should come as a surprise to anyone that, given the losses sustained in the 2000 to 2002 bear market, many of which are still sitting on mutual funds’ books, tax efficiency remains fairly high pretty much across the board.

Tax Efficiency Doesn’t Equal Better After-Tax Returns

But tax efficiency doesn’t necessarily translate into better after-tax returns, nor does it tell you which funds are “best.” I’m sure you’ve heard that index funds are tax efficient, and that this makes them attractive.

First off, not all index funds are tax efficient. Second, those that are tax efficient aren’t necessarily going to put more money in your pocket as a result.

Over the last three years, for instance, Growth Index (VIGRX) was one of Vanguard’s most efficient index funds, losing just 1% of its total return to taxes. Yet, many funds with lower tax efficiency, like PRIMECAP (VPMCX) and PRIMECAP Core (VPCCX), outperformed Growth Index on an after-tax basis. Even Growth Equity did!

Speaking of Growth Equity (VGEQX), because of all the losses the fund has sustained, it’s got the best five-year tax-efficiency of any Vanguard fund, at 99.7%. Does this make it a buy? Absolutely not. That tax efficiency didn’t help the fund in the after-tax total return derby. It substantially underperformed its large-growth peers and generated a return that was below that of the stock market.

Also, the supposed advantage of the Tax-Managed funds has to be called into question. Here’s one example: Tax-Managed International (VTMGX) had one of the highest tax efficiency numbers among all Vanguard funds over the past five years.  Yet, on an after-tax basis the fund underperformed several of Vanguard’s other international funds including Total International Index (VGTSX). Is it worth paying the Tax-Managed fund’s higher minimum while being locked into a 5-year, 1% back-end load just to underperform after taxes?

Even Vanguard tax maven Joel Dickson probably doesn’t think so. As he puts it, “At the end of the day, the question is whether you have created wealth, not how much you have reduced taxes.” Amen to that.

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