Taxes can have a huge impact on investment returns.  The main issue: active trading typically generates large tax bills that can reduce your returns by 20%.  That’s a huge hit, and often goes unnoticed.

So what do you do?  Invest in “passively managed” funds that generally buy and hold, not in actively managed mutual funds.  Most of the returns from more aggressive funds represent short-term capital gains, which are taxed at rates as high as 35%.  That compares to long-term capital gains tax of 15%.  So, an actively managed fund with a 10% pre-tax return could net an investor as little as 6.5% after-tax (ignoring state taxes), compared to a passively managed fund that could net closer to 8.5% after-tax.  In fact, passively managed funds have an even greater advantage, because that lower tax is deferred for years, until the manager actually sells.

Maybe you are thinking, “Sure, but don’t active managers generate a better pre-tax return?”  The evidence proves just the opposite is true.  Active managers under-perform due to higher fees and trading costs, and then the tax bill drags your return down even further.

If you are not sure whether a mutual fund is actively traded, check the annual turnover (the percentage of the fund’s holdings traded every year).  If it’s over 25% or so, you will probably pay way too much tax.  By contrast, most of the stock funds I use have an annual turnover well below 25%.

Active managers hope you won’t make the connection between your investment statement and your tax bill.  But you have to.  Otherwise, taxes will take a huge bite out of your returns.