Last year, mutual fund investors paid approximately $31.3 billion to the Internal Revenue Service, according to a recent study by Lipper. "Taxes in the Mutual Fund Industry" looks at the tax implication to investors of nearly $2.91 trillion in mutual funds held in taxable accounts.

"People are giving up at least 40% to 50% of their gross returns [to taxes, expenses, and loads]," said Tom Roseen, research analyst and author of the study.

The study presents a worst-case performance scenario for an investor in the highest tax bracket who invested in the U.S. diversified equity fund group, a composite of equity funds that accounts for 80% of pure equity mutual funds. Over the last five years, an investor would have lost 40% of gross returns to taxes, fund expenses and loads, reducing a gross annualized return of 10.47% to 6.25%.

A similar scenario for a bond fund investor uncovered a loss of 86% of gross returns, reducing a gross annualized return of 5.81% to 0.81%.

Lipper’s study uses the highest tax bracket, 38.6%, to calculate tax impact, following the guidelines set by the Securities and Exchange Commission for federal reporting of after-tax performance of mutual funds. While most mutual fund investors may be in a lower tax bracket, using the high estimate still provides valuable information for investors, Roseen said.

If most fund investors were middle income, they would be in the 28% tax bracket, he said. "The difference between 28% and 38.1% is relatively small, only 10 basis points. The difference between zero and 28% is huge," Roseen said.

Furthermore, Roseen pointed out that the 38.1% rate may provide a fairly accurate estimate of a middle income investor’s total tax liability, including state and local taxes. "[The SEC’s after-tax performance rate] takes into account only federal taxes, so in essence it underestimates what those high tax bracket payers would be paying," he said.

The solution? Funds that don’t specialize in tax management should still keep an eye of tax consequences, Roseen said. "We suggest that fund boards urge mangers to become more conscious of tax implications," he said.

Although fund managers should already be doing so, many are dropping the ball, Roseen said. "I think they should be, but I don’t think they are. I think we can get some extra basis points out of there for investors, even for non-tax-managed funds."

Subscribe Now

Access to premium content including in-depth coverage of mutual funds, hedge funds, 401(K)s, 529 plans, and more.

3-Week Free Trial

Insight and analysis into the management, marketing, operations and technology of the asset management industry.