Nobody would buy a house without knowing how high the taxes are. Yet everybody buys shares in mutual funds without any idea how big a bite taxes will take out of their investments.

That sad and silly situation exists because mutual funds today are required to publicly disclose rates of return only before taxes, not after taxes. Investors trying to comparison-shop simply have no way to tell which of two funds with identical before-tax returns is in fact the poorer investment because it hands over more money to the tax man.

All that will change if the Securities and Exchange Commission swiftly enacts its well-reasoned proposal requiring mutual funds to disclose after-tax rates of return. With millions of Americans investing trillions of dollars in taxable mutual funds, this rule will likely prove to be the most important and far-reaching the SEC will act on this decade.

Funds’ Tax Efficiency Varies Widely
Some mutual funds lose as much as 5.6 percentage points of their total returns each year to taxes, a recent study showed. Others lose nothing. The average tax bite is 2.5 percentage points. But it is currently possible for three different funds – the least tax-efficient, the most tax-efficient and the average – to report the very same before-tax performance to the investing public.

Ironically, many investors pore over tiny differences in mutual fund fee structures. Yet fees, on average, reduce returns by about a percentage point less than the 2.5 percentage points lost to taxes.

Some funds, led by The Vanguard Group, are voluntarily disclosing after-tax returns. And, as of January, my own firm, Confluence Technologies, Inc., updated our FundStation software system so that our clients, representing some 40 percent of U.S. mutual fund families, can automatically calculate daily rates of return after taxes, as well as before taxes, if they wish.

But investors need after-tax information from all funds, all the time, in a consistent and clearly presented format. That is why the SEC ought to enact its after-tax disclosure proposal as soon as possible, and almost in its entirety.

Keep the Proposal Intact -- Almost
The SEC heard from plenty of critics in the public comment period that ended June 30. Its main task now is to resist pressure to change the all-important details of just how after-tax returns should be calculated. Here are the key issues the SEC is grappling with:

Calculate after-tax returns using the maximum federal tax rate. Funds should calculate after-tax performance assuming that the distributions they make to their shareholders, as well as the individual shareholder’s gains and losses on sales of fund shares, are taxed at the highest individual federal income tax rate. Sure, a lot of investors will pay taxes at lower rates. But a calculation based on the highest tax bracket gives all investors a “worst-case ” scenario – an upper boundary they can compare against the fund’s before-tax return to see the full range of potential returns.

Some critics have talked of figuring out separate rates of return for the different tax brackets, or of estimating the return for a mythical "average investor." But there are a lot of practical problems with both approaches, and neither would be as useful to investors as the single, consistent worst-case figure.

Leave out state and local taxes. Stick to the impact of federal taxes, and don’t even think about asking funds to compute the thousands of state and local taxes that could apply. A standard figure that applies to investors across the nation is not only easier to produce but far less confusing.

Apply historical, not current, tax rates. When a fund makes a distribution, the only tax rate that properly applies is the one in effect at the time of the distribution – the historical tax rate. It’s been suggested that no matter when a distribution was made, a fund should be able to retroactively apply the current tax rate – that is, whatever rate’s in effect when the fund gets around to calculating its after-tax return. That’s backward, and it would make after-tax return figures just plain wrong.

Use actual holding periods when applying taxes to capital gains. Funds ought to track the actual holding periods of reinvested distributions and apply the appropriate tax rates for each reinvestment and the initial investment. Of course, everything would be so much simpler if funds could simply assume that distributions were held for the same period as the initial investment. But in the real world, multiple capital gain rates do exist; they can vary significantly and severely penalize an investor’s most recent gains. Funds have the means to calculate this, and should be required to do so.

Help investors compare funds with different load structures. The SEC has proposed that funds report after-tax returns in two different ways: pre-liquidation and post-liquidation. Simply put, the pre-liquidation return gauges the tax efficiency of the portfolio manager’s decisions to buy and sell securities. The post-liquidation return goes further; it shows not only the portfolio manager’s tax efficiency, but also the effect of the individual investor’s decision to sell shares in the fund at a taxable gain or loss.

There’s one problem with this approach: the pre-liquidation return reflects front-end sales charges, but not back-end sales charges, since back-end charges apply only when the investor sells his shares in the fund. The back-end load does show up in the post-liquidation return, but it’s obscured by the additional taxes that come with the sale of fund shares. The proposed rule makes front-end loaded funds look worse and back-end loaded funds look better, and investors trying to compare funds with different sales charge structures are left in the dark.

Here’s a way around the problem: drop both the before- and after-tax pre-liquidation returns, and replace them with a single new calculation – call it the Rate of Return Net of Sales Charges and Taxes on Fund Distributions. Granted, the term is a bit cumbersome, but the concept works: the new figure would set aside the tax impact of the shareholder’s individual decision to buy or sell fund shares, thus isolating the tax impact of the portfolio manager’s decisions and giving investors a consistent number to use in comparing funds. Stick with the SEC’s plan to offer two other figures – before-tax and after-tax returns, both post-liquidation – and investors have the fullest possible picture of a fund’s performance.

Discussion of such fine points must not obscure the main point: that the SEC should be commended for its proposal to disclose the after-tax performance of mutual funds. Mutual funds are the main investment vehicle for millions of small investors who have leaped into the stock market in recent years, and the SEC’s new rule will greatly benefit a broad cross-section of American society.

Mark Evans is president of Pittsburgh-based Confluence Technologies, Inc., the nation’s leading provider of investment performance measurement systems for mutual funds.

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