After-tax returns provide an estimate of a fund's annualized tax- and load-adjusted total return for the time period specified. Morningstarís data is consistent with the SECís 2001 guidance about after-tax returns, and it is updated as needed to reflect changes in the federal tax code.
Taxes are a significant consideration for many investors who own mutual funds in taxable accounts. When a fund receives a stock dividend or interest from a bond, it will divide that dividend among its shareholders, and when a fund sells a security at a gain, it will divide that capital gain among its shareholders. Investors pay taxes on these dividends and capital gains, and they may also pay taxes on capital gains when they sell the fund.
Investors can compare the total return, load-adjusted return, and after-tax returns for a fund to understand how loads and taxes affect the performance of the fund. Investors can also use after-tax returns to compare one fund to another.
Morningstar calculates after-tax returns in-house on a monthly basis, using price and distribution data for each fund for different time periods. Morningstar calculates after-tax returns for open-end mutual funds, exchange-traded funds, and variable annuity underlying funds. The following description applies to those funds that are domiciled in the United States.
The after-tax returns calculation is based on a few underlying assumptions that may cause the results to be slightly different than what each individual investor experiences.
Per the SECís guidance, Morningstar uses the highest federal tax rate prevailing for each type of distribution. These results simulate the tax effects for an individual in the highest tax bracket.
After-tax distributions are reinvested.
State and local taxes as well as individual-specific issues are ignored.
Per the SEC's guidance about this topic, all after-tax returns are also adjusted for loads and recurring fees. Therefore, these are technically "tax- and load-adjusted returns" and not simply "tax-adjusted returns." A fund's after-tax return may be lower than its total return because of tax effects, sales charges, or both.
Morningstar uses the maximum front-end load and the appropriate deferred loads or redemption fees for the time period measured. Sales loads are not applied to reinvested distributions.
Morningstar applies the appropriate historical tax rate based on the date of the distribution. The current tax rates are as follows:
35% interest income and non-qualified dividends
15% qualified dividends
35% short-term capital gains
15% long-term capital gains
For municipal bond funds, Morningstar will only adjust for capital gains taxes, as the income from these funds is generally exempt from federal tax.
Stock dividends can be either non-qualified or qualified, as defined by the 2003 Jobs and Growth Tax Relief Reconciliation Act. If fund companies tell Morningstar which portion of the dividend is qualified, the tax-adjusted returns will reflect the appropriate tax rates. If fund companies neglect to denote the type of dividend, Morningstar will assume that it is non-qualified and will apply the higher rates. In practice, most fund companies do not specify to Morningstar if their distributions are eligible for this lower tax rate. Also, the NASDAQ nightly pricing feed for mutual funds is not equipped to distinguish between qualified and non-qualified dividends. As a result, since most U.S. stock dividends qualify for a lower tax rate, some domestic stock funds with sizable yields may have understated after-tax returns in our system.
There are two types of returns: Return After Taxes on Distributions and Return After Taxes on Distributions and Sale.
For tax purposes, this set of returns is based on the assumption that the investor does not sell their fund shares at the end of the time period. These returns reflect the taxable effects of fund distributions to the shareholders. These returns do not reflect any taxable gain or loss the shareholder would have realized upon selling the fund shares. Note: These returns reflect all applicable sales charges. Therefore, for loads, we assume that the investor did sell their fund shares at the end of the time period and did incur any applicable deferred loads or redemption fees.
This set of returns is based on the assumption that the investor does sell their fund shares at the end of the time period. As a result, these returns reflect both the taxable distributions by a fund to its shareholders and any taxable gain or loss realized by the shareholder upon selling the fund shares. These returns reflect all applicable sales charges.
Morningstar After-Tax Return Research Paper