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Stiff-Arm the Taxman

Welcome back to another edition of Foolish mutual fund basics. This time, we're leaving behind the sugar shack where fund managers live for the weary ward of the tax collector. Ready to get started? Good.

What it is
I won't blame you if "tax efficiency" sounds like the process of filing your annual returns on time. Sadly, it isn't. Instead, it's a term used to describe how well the manager you're investing with keeps hold of paper gains in his fund's portfolio.

Why? Every time he cashes in an investment or earns a dividend, that's money that you, the investor, must be paid by way of a distribution. And each time that occurs, it's a taxable event. Not that you'll receive checks all year long. Instead, funds tend to keep careful records and, in December, pay you everything at once.

For fund junkies like Motley Fool Green Light co-advisor Shannon Zimmerman, who also oversees our Champion Funds service, this time of year is known as "distribution season." It's a dangerous time for owners of funds that sport high turnover or sloppy management. They're likely to get stuck with a hefty bill from the IRS come April.

How it works
But it doesn't have to be that way. As Shannon explains in a past issue of Champion Funds, "Crafty fund managers can reduce and perhaps even eliminate the payout if they have and choose to deploy 'tax-loss carryforwards,' prior-year losses that can be saved up (so to speak) and used to offset current-year gains."

In other words, funds can be like stocks in that losses can offset capital gains. The key difference is that stock investors control what they buy and sell and, thereby, have some say in the final tax bill. Fund investors have no control whatsoever.

And it gets worse. The IRS doesn't care what you do with the proceeds you receive. Even if you reinvest to take advantage of a lower net asset value (NAV) -- more on this in a later column -- you'll still need to pay the Feds their cut of the proceeds.

That's why Shannon places a premium on tax management in making picks for the Champion Funds portfolio. As he writes in the newsletter, "among the other criteria I use, I focus on a fund's tax efficiency -- i.e., how much of its pretax return it has delivered to shareholders on an after-tax basis. This data point isn't determinative -- no one statistic is -- but it's certainly among the factors that I consider before issuing a recommendation."

Go under the hood
How can you tell if a fund is tax-efficient? Two ways. First, take a look at the average portfolio turnover at Yahoo! Finance. Second, check the "Tax Analysis" tab at Morningstar.

What you're looking for is a fund that buys and sells securities far less often than peers and, as a result, delivers unencumbered gains to investors. Take Richie Freeman'sLegg Mason Partners Aggressive Growth (FUND: SHRAX  ) , for example. Annual turnover is just 4% vs. the category average of 99%.

But that can't be too surprising. Freeman has earned a reputation for sticking by growth-stock bargains when he finds them. Two top 10 holdings, Comcast (Nasdaq: CMCSA  ) and Forest Laboratories (NYSE: FRX  ) , have been in the fund's portfolio during all 23 years of Freeman's tenure.

What's more, Morningstar shows that Aggressive Growth is in the top 1% in its category in terms of 10-year tax-adjusted returns. Even today, only 38% of the portfolio would be exposed to capital gains were Freeman to begin selling. Both are very good signs for the tax-conscious fund fan.

Follow the money
Taxes are a necessary burden in both life and investing, but you don't have to be happy about it. So, when choosing funds, pay attention to portfolio turnover and historic after-tax returns. Has your manager excelled in these areas? If so, great. If not, what makes you think he'll do any better beating the market on a pre-tax basis? It's worth asking.

And, in the meantime, consider Motley Fool Green Light if you're interested in more moneymaking tips. Shannon and co-advisor Dayana Yochim are offering 30 days of free access to the service. Click here to get started right now.

Interested in more mutual-fund basics? Your digital chariot awaits:

Fool contributor Tim Beyers, ranked 1,522 out of more than 19,600 in Motley Fool CAPS, didn't own shares in any of the companies mentioned in this article at the time of publication. Get a peek at everything he's invested in by checking Tim's Fool profile. The Motley Fool's disclosure policy is never taxing.


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Tim Beyers
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Tim Beyers first began writing for the Fool in 2003. Today, he's an analyst for Motley Fool Rule Breakers and Motley Fool Supernova. At Fool.com, he covers disruptive ideas in technology and entertainment, though you'll most often find him writing and talking about the business of comics. Find him online at timbeyers.me or send email to tbeyers@fool.com. For more insights, follow Tim on Google+ and Twitter.

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