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Believe it or not, some people actually have investments outside of their tax-deferred IRA’s, 401(k)’s and other retirement plans. Typical sources of what are termed “after-tax” accounts can be the proceeds from selling a house, inheritances, selling a business interest, cashing in some stock options, receiving Required Minimum Distributions (RMD’s) and finally --- heaven forbid --- there are people who actually save and invest some of their take-home pay on an annual basis after maxing out their 401(k)’s.

Since capital gains and dividend distributions on these taxable assets are not deferred as they are in retirement plans, the successful management of this money over time depends upon how effectively the management of the funds reduces the annual tax bite and leaves as much as possible of the earnings on the table to grow by compounding.

When you buy a mutual fund for $1,000 and sell it seven years later for $2,000, you would pay a capital gains tax on your $1,000 profit. However, during the time you have owned a fund fortunate enough to have made profitable trades during your ownership period, the fact that you have paid at least some taxes on those trades from year to year is taken into consideration when you sell the fund. In this example, you may have already paid taxes on $500 of your $1,000 profit, so you only owe taxes on the remaining $500. The fund companies keep track of your original purchase price and the capital gains you have experienced and paid taxes on from year to year.

A typical actively-managed fund will have “turn-over” of 50 percent or more. This means that half of the stocks owned at the beginning of the year will be sold by year-end. Turnover, when it’s successful, is what triggers these annual capital gains distributions. If the mutual fund does little or no trading and the share prices of the underlying companies rise, the capital gains within the fund are “UN-realized” and investors just sit there watching their investment value rise without having to scramble to find money to pay capital gains taxes.

A typical index fund investing in a broad cross section of stocks and leaving them alone, like a 500 index fund, will have a negligible 3 percent turnover. When your $1,000 rises to $2,000, you pay capital gains tax on just the amount you feel like selling. In other words, you control the timing of when you pay the tax. By comparison, paying taxes on an ongoing basis because of turnover typically turns a 10 percent market return into an 8 percent after-tax return, and this explains why managed money does such a poor job of beating after-tax market averages. Beyond index funds, another approach is to invest in individual stocks and not trade them.

The implosion of the stock market back in 2008 prompted many mutual funds to have to sell stocks at a huge loss to meet investor redemption requests. Consequently, funds had an opportunity to “harvest their losses” which gave them something to use to offset the gains they enjoyed over the next 5 years. Until about 2014, the typical mutual fund invested in stocks had relatively little in the way of capital gains that were not offset by those previous losses. That was then. This is now.

Going forward, it makes sense to manage after-tax money judiciously with an eye to minimizing the tax bite. On managed funds over the past five years, even as many of those years benefited from loss carry forwards created by the worst crash in 70 years, the difference in pre-tax and after-tax returns was still as much as one full percent per year. The difference between earning 10 percent versus a net 9 percent after paying taxes has a huge affect on dollars accumulated over ten and twenty years. At www.thecalculatorsite.com you can play around with numbers and see for yourself.

The answer is to consider index funds or Exchange Traded Funds that do very little trading. At the same time, some managed funds with minimal turnover have tax efficiency as the engine driving their trading decisions, so with these funds the net after-tax returns can be as high as 95 percent of the pre-tax number. What makes this tax consideration important is the exponentially greater impact of the last percent or two of annual returns. Therefore, we can increase returns by saving taxes with 100% certainty. By comparison, it is impossible to know, prospectively, which mutual funds will generate enough additional performance to offset the higher tax burden they create.