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Using Morningstar’s Tax-Cost Ratio

When I’m looking for information about a mutual fund, Morningstar is typically the first place I look. In addition to the most obvious pieces of information such as the fund’s expense ratio and portfolio composition, one thing I often check is the fund’s “tax-cost ratio.” (To find a mutual fund’s tax-cost ratio, look up the fund on Morningstar and click over to the “tax” tab.)

What Is Tax-Cost Ratio?

Morningstar’s tax-cost ratio figure shows what an investor in a given fund would have paid in taxes over a given period, if the investor was in the highest tax bracket throughout the period in question.

The figure is expressed as a percentage of fund assets, making it analogous to a fund’s expense ratio in that a fund’s expense ratio tells you what percentage of your investment is eaten up by fund expenses each year, while the fund’s tax-cost ratio tells you what percentage of your investment would have been eaten up by taxes over a given year (assuming that you were in the highest tax bracket that year).

What Is Tax-Cost Ratio Useful For?

Tax-cost ratio can be very helpful for comparing different funds or categories of funds to see which ones are more tax-efficient.

For example, a comparison between Vanguard Total Stock Market ETF and Vanguard Total Stock Market Index Fund shows that their tax costs are nearly identical. And a comparison between Vanguard Total Bond Market ETF and Vanguard Total Bond Market Index Fund provides a similar result. (Conclusion: If you’re trying to decide which share class of these funds to own, taxes are probably not going to be a major factor in your decision.)

Or, if you were to meet with a financial advisor who recommended, for example, American Funds’ Growth Fund of America as a holding in your taxable account, you could compare that to an index fund in the same fund category (e.g., Vanguard Growth Index Fund), and you would find that Growth Fund of America tends to experience higher tax costs. (This should not be particularly surprising. Actively managed funds tend to be less tax-efficient than index funds, because they have higher portfolio turnover.)

What Tax-Cost Ratio Is Not Useful For

You’ll want to be careful, however, not to use tax-cost ratio for purposes for which it is not intended. For example:

  • Tax-cost ratio is not relevant for holdings within an IRA, 401(k), or other tax-sheltered retirement account, because you do not have to pay taxes each year on the gains that you earn in those types of accounts, and
  • Tax-cost ratio is not particularly helpful from a budgeting, how-much-tax-should-I-expect-to-pay perspective, because the figure is historical and therefore naturally dependent upon the returns the fund earned over the period in question, and
  • Because the tax-cost ratio calculation uses the assumption that the investor is in the highest tax bracket at all times, it’s not a good estimate of how much you would have paid in taxes, unless you really did happen to be in the top tax bracket for each of the years in question.

In other words, tax-cost ratio is useful for comparing two different funds or groups of funds to see which tends to be more or less tax-efficient when held in a taxable account. But the actual specific figure isn’t necessarily going to be very useful from a forward-looking perspective.

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