The Bogleheads' Guide to Investing, 2nd Edition

Chapter Ten Taxes: Part One: Mutual Fund Taxation

The profound impact of taxes on fund returns is a subject too long ignored.

—Jack Bogle

In Chapter 9 we learned about the importance of costs and how they reduce mutual fund returns. In this chapter we will discuss the biggest cost of all—taxes. When we understand how taxes are assessed on mutual funds, we can devise ways to significantly reduce the tax drag on our returns. Sir John Templeton rightfully stated, “For all long-term investors, there is only one objective—maximum total return after taxes.”

THE DEVASTATING IMPACT OF TAXES

Many studies have been done to determine how federal taxes reduce mutual fund returns to fund shareholders. One of the longest studies, commissioned by Charles Schwab, was for the 30-year period from 1963 to 1992. The study found that a high-bracket taxpayer who invested $1.00 in U.S. stocks at the beginning of that period would have $21.89 at the end of the period if invested in a tax-deferred account. Meanwhile, the same $1.00 would have grown to only $9.87 if invested in a taxable account—less than half as much. These figures clearly show that taxes, plus the impact of compounding, make a tremendous difference in after-tax performance.

Jack Bogle did a 15-year study ending March 30, 2009. He found that the average equity mutual fund return was 5.4 percent before taxes and 3.7 percent after taxes—an annual tax-drag of 1.7 percent. During the same period, the more tax-efficient Vanguard S&P 500 ...