Mutual fund investors are taxed on their investments in three ways

TAX EFFICIENCY

Most mutual fund investors mistakenly overlook the issue of tax efficiency when purchasing mutual funds, and yet it can have as large an impact on your total return as the fund’s expenses or even its performance.

The factor which most drives the tax efficiency of any given fund is its turnover ratio – how often the investments within the portfolio are bought and sold during the year. Funds looking for conservative, steady long-term returns are likely to have lower turnover ratios – and as a result higher tax efficiency – than aggressive funds looking for sharp short-term gains. Funds usually report their tax efficiency ratios on their prospectuses, and some fund companies have begun to report after-tax returns on their Web sites.

Keep in mind that, if you hold your funds in a 401(k) or other tax-deferred retirement account, the issue of tax efficiency is mostly moot, as dividends and capital gains accrue tax-deferred until you draw from the account.

Taxes

Mutual fund investors are taxed on their investments in three ways – the sale of shares, capital-gains distributions and dividend distributions.

When you sell your shares, you must pay capital-gains taxes on any profit that you made. Likewise, you can declare a loss on the investment if the shares decreased in value. The amount of gain or loss is determined by the difference between the sale price and the “cost basis” of the fund shares (generally the purchase price).

DISTRIBUTIONS

Mutual fund investors are also taxed on the two types of distributions that mutual funds make to shareholders during the year – dividends and capital gains.

Dividend distributions are primarily from the interest and dividends earned from the investments in the fund’s portfolio. These must be reported as income on your 1040 federal tax form.

Capital-gains distributions represent any gains from the sale of shares held more than a year that the fund itself made during the year. These are taxed as capital gains, often at lower rates than federal income taxes.

Fund investors are often befuddled by a large drop in the share price of their fund when distributions are paid out. In such cases, while the share price may have dropped sharply, the number of shares in the fund -- and the number of shares you own – increased proportionately, meaning the value of your investment stayed the same.