Are You Sitting on a Tax Time Bomb?

If you wanted to stave off the tax collector, you might look for funds with strong aftertax returns. Or you could search for funds with low tax-cost ratios, which measure the percentage of a fund's return that it has sacrificed to taxes. Those certainly are useful steps, but they won't offer a complete picture.

Just as past returns don't predict future returns, a history of strong tax efficiency doesn't assure it in the future. In fact, it's possible you might be sitting on top of a tax time bomb without even knowing it. So, how can you know if that's the case? Fortunately, Morningstar offers an effective tool you can use to do just that. Read on to find out more.

How to Judge Future Tax Efficiency
Fund investors' tax troubles begin when paper profits become reality as fund managers sell investments for a gain. The law requires mutual funds to pass on all income and realized profits, or capital gains, to their shareholders on an annual basis. If a manager has made a gain in a stock or bond but hasn't sold any shares, the fund isn't required to pay out capital gains. Those gains--called unrealized gains--sit on a fund's books until a manager sells.

That's why, if you're searching for a fund for your taxable account, it makes sense to see what kind of paper profits, or unrealized gains, funds have on their books. The fund won't necessarily pay out all of those gains at once or any time soon, but it's nonetheless a factor to bear in mind.

The best way to assess the magnitude of a fund's unrealized gains is to look closely at its potential capital gains exposure, a metric you can find under the Tax Analysis tab of the Morningstar report for any fund. The PCGE estimates the percentage of a fund's assets that are represented by gains. The larger the PCGE, the bigger tax liability shareholders could face.

Of course, a hefty PCGE doesn't necessarily mean big capital gains payouts are in the offing. No one has to pay taxes on unrealized gains, and if your manager is content to sit tight with his holdings for long periods of time, big capital gains payouts may never be a problem. But the likelihood increases the more a portfolio manager turns over his or her portfolio. That obviously includes aggressive, rapid-trading strategies, but changes in management or strategy can also trigger turnover. (You can find a fund's turnover rate under the Snapshot tag of its Quicktake report.) Another lesser-known threat stems from when shareholders flee. As investors jump ship, managers may have to sell stocks to meet redemptions, possibly triggering gains. That's a particular risk after a fund has enjoyed an impressive stretch of returns. The performance chasers who bought the fund on account of strong returns will quickly dump it when performance heads south, leaving long-term investors holding the tax bag. Even worse, there are a smaller number of investors that the capital gain will be spread over, leaving shareholders with a bigger tax bill than they might've had otherwise.

By contrast, funds with negative PCGE may be tax-efficient for some time. These funds' accumulated past losses are actually greater than the net assets of the funds. That's possible because tax law allows funds to take, or carry forward, any net losses they suffer in a given year and apply them toward their gains for up to seven years. In many instances, a negative PCGE is a bad sign. After all, funds with negative PCGE have probably lost a lot of money for shareholders. Still, there are instances where it's a big plus. Take FPA Paramount (NASDAQ: - ), for instance, which got a new management team in 2000. The incoming managers swept out their predecessor's losing picks, creating a hugely negative PGCE. The new team brought the same successful approach they've used at sibling FPA Perennial (NASDAQ: - ), but Paramount has been much more tax efficient. (After several years of gains, however, Paramount's tax advantages have diminished, and it now has a barely negative PCGE.)

It's worth noting that a negative PCGE in the past could give a misleading view of future tax efficiency. Aggressive, high-turnover funds are notorious for heavy capital gains payouts, but they've actually been quite tax-efficient in recent years because they've been able to use the steep losses they suffered in the early 2000s' bear market to offset the gains they've enjoyed in the ensuing rally. Nearly five years of stock market gains have evaporated those losses, so even though the higher-turnover growth categories generally have the lowest PCGEs, it's likely that they'll be less tax-efficient in the future than they've been in the recent past

Where Are the Biggest Tax Traps Today?
A recent study by my colleague Bill Rocco in Morningstar FundInvestor showed that greater tax threats lurk in value, small-cap, and international funds, however. These areas have rallied most strongly in recent years, so it's not surprising that these groups sit on the biggest pile of gains. At the end of 2006, the median PCGE for the domestic value and blend categories ranged from 14% to 18%, with funds such as Oak Value (NASDAQ: - ) and Neuberger Berman Genesis (NASDAQ: - ) clocking in at 35% and 40%, respectively. On the whole, foreign funds look even worse, with more niche groups such as small caps and emerging markets racking up the largest potential gains. American Funds EuroPacific Growth's (NASDAQ: - ) PCGE weighs in at 37%, for instance, while T. Rowe Price Latin America's (NASDAQ: - ) stands at a very hefty 48%. We're not predicting that the funds will pay out big capital gains anytime soon, but it's still a consideration for would-be investors.

Finally, tread carefully before buying certain sector funds. The multiyear rally in commodities prices has fueled big gains at natural-resources and precious-metals funds, making many of them ticking tax time bombs. Think especially hard before delving into a real-estate fund. These funds' heavy income streams make them tax-unfriendly to begin with, but the long real estate rally has left them with huge embedded capital gains.

Is There a Way Out?
We're certainly not arguing that you shouldn't invest in an international or a value fund (though their extended runs may mean you might want to enter cautiously). You could consider holding funds with big potential tax liabilities in a tax-deferred account, such as your 401(k) or IRA. Or as an alternative, take a look at tax-managed funds. These funds are explicitly designed to avoid taxable distributions. Vanguard's tax-managed lineup, which includes large-cap Vanguard Tax-Managed Appreciation (NASDAQ: - ) and Growth & Income (NASDAQ: - ), Tax-Managed Small Cap (NASDAQ: - ), and Tax-Managed International (NASDAQ: - ), are great ways to invest in taxable accounts. (For more on how you can limit Uncle Sam's take, click here.)

In the end, though, you don't want to pay attention to tax considerations at the expense of all else. As an investor, your goal should be to earn the largest possible aftertax return, not simply to avoid paying taxes altogether. By all means, invest with taxes in mind, but remember that your first job should be to identify superior funds--those with seasoned managements, strong long-term returns, and low expenses--first.

Christopher Davis does not own shares in any of the securities mentioned above.