62 The Taxman Cometh for Your Fund Returns

The Taxman Cometh for Your Fund Returns

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Although taxes can chew through your mutual fund returns when you invest in a taxable account, the new tax law of 2003 can trim your tax bill.

The 2003 tax law is Washington's gift to the long-term investor, offering substantial cuts in the tax rates on both capital gains and dividends. For investors using taxable accounts, buying and holding makes more sense than ever before. Because distributions of capital gains and dividends are taxable in these accounts, you must pay taxes on all of your distributions, whether you receive them in cash or reinvest them in fund shares. Paying taxes on distributions can cost you 2 to 3 percentage points of return each year. To make matters worse, when you reinvest mutual fund distributions, you must come up with cash from somewhere else to pay the taxes on those distributions on April 15. However, if you buy shares in tax-efficient funds to begin with, and then choose the shares you sell wisely, you can minimize your pain at tax time.

Uncle Sam is watching you and your fund company, and come April 15 he wants his cut. As a fund investor, you should evaluate the tax ramifications of the following mutual fund actions:

  • Selling shares of a fund that has increased in value.

  • Receiving interest from bond, money market, and REIT funds, distributed monthly to fund investors and taxed as ordinary income.

  • Receiving capital gains from any fund, including municipal bond funds.

  • Writing checks from any type of fund account other than a money market account, which triggers a sale of shares and is potentially taxable.

  • Exchanging (selling) shares in one fund family for another in the same family. If the exchange is in a taxable account, you'll owe taxes on any gains.

The 2003 tax law cuts corporate dividend and long-term capital gain rates to 15 percent through 2008. If the law isn't renewed before 2008, these rates go back to their pre-2003 levels. Fund managers and investors who hold stocks and bonds for a year or longer shelter more of their own profits as a result of the new law. Likewise, fund managers and investors favoring dividend-paying stocks also benefit. The new law punishes short-term traders—managers or investors who hold stock, funds, or other assets for less than a year—with high tax rates.

Over time, the tax-savvy long-term investor's returns will far outpace those of the short-term trader, as invested principal grows and compounds. There's a big gulf between tax-aware managers who hear investors' pain over high tax bills and the happy-go-lucky manager who reaches for high returns at all costs. The two funds in Figure have similar objectives. Both outperform market benchmarks during the long term, are managed by long-term managers, and charge low expenses. Although their pre-tax annual returns are fairly close, the after-tax return of the tax-inefficient fund is only 68 percent of the tax-efficient fund return, and produces almost $11,000 less on a $10,000 investment over 10 years.

Taxes can take a huge bite out of mutual fund returns


Ten-year pre-tax return in percent

Ten-year after-tax return in percent

Percentage lost to taxes

Dollar difference investing $10,000 for ten years

Muhlenkamp Fund





Gabelli Equity Income





While stock investors cheered the 2003 tax cuts, investors in bonds and real estate investment trusts (REITs) weren't so happy. Whether you invest in bonds and REITs directly or through mutual funds, you are taxed at ordinary income rates on their income.

Municipal bond funds offer investors a haven from high tax rates. These bond funds make sense for investors who live in high-tax states and hit federal tax brackets of at least 27 percent. InvestinginBonds.com (http://www.investinginbonds.com/cgi-bin/calculator.pl) offers a simple calculator that helps you figure out whether you're better off investing in taxable or tax-free bonds or bond funds. When you compare taxable and tax-free funds, remember to pick funds with similar durations and credit quality. Duration [Hack #64] measures a fund's sensitivity to interest rate changes, whereas credit quality assesses the financial stability of the companies issuing the bonds in the funds' portfolios.

Before you buy shares in any kind of mutual fund for a taxable account, look under the hood for hints on management tax strategies and potential tax issues. Morningstar.com provides pre-tax and tax-adjusted returns as well as other tax statistics when you select the Tax Analysis tab on a Snapshot report web page:

Pre-tax return

Total return including reinvested capital gains and income prior to paying taxes.

Tax-adjusted return

Total return with all capital gains and income distributions taxed at the maximum federal rate at time of distribution and the after-tax portion reinvested in the fund. If you invest in taxable accounts, use this measure to evaluate which fund provides the better return taking your tax bill into account.

Tax cost ratio

The percentage reduction in annualized return resulting from income taxes. Look for numbers under 1 percent for taxable accounts.

Potential capital gains exposure

The percentage of a fund's total assets that would be subject to capital gains taxation if it were to liquidate. This measure indicates how likely the fund is to distribute capital gains in the future. A negative potential capital gains exposure means that fund carries capital losses it can use to offset future gains. A positive number indicates the potential for capital gains distributions in the future.

Morningstar Snapshot reports include other measures you can use to evaluate tax efficiency:

Turnover rate

Shown on the Snapshot page, this is the percentage of a fund's net assets sold in a year. Look for lower numbers for taxable accounts.

Morningstar rank

Shown on the Morningstar Rating page, this is the rank within the fund category, which is calculated based on tax-adjusted returns for funds with similar investment strategies.

1 Tax Avoidance Strategies

All is not lost. There are plenty of ways you can minimize your mutual fund tax bill:

  • Hold tax-inefficient mutual funds in 401(k) and IRA accounts when possible.

  • Contribute the maximum to 401(k) and IRA plans before investing in taxable accounts. Although capital gains rates are low now, that won't last forever. Deferring taxes over a long period of time juices your returns, adding to the powerful effect of compounding.

  • Invest in tax-managed funds in taxable accounts. Most large fund families offer several tax-managed funds with different investment options.

  • Don't make purchases in tax-inefficient funds late in the year. Funds must distribute their capital gains, dividends, and interest before December 31, so the shares you purchase in November or December are like buying the distribution and paying taxes on gains that you didn't earn.

It's also a good idea to check a fund's distribution dates before buying and selling at other times. Don't buy a fund right before a quarterly distribution or sell immediately after one.

  • Check your potential gains in a fund before exchanging it for another fund in the same fund family. Such an exchange is a sale for IRS purposes and could trigger capital gains. If your capital gains are large and you need the money, set aside 20 percent of your profits to pay taxes on the capital gains.

  • Use losses to offset capital gains. If you own shares in a poorly performing fund, sell it to offset gains in other parts of your portfolio. Even if you don't have gains, dump that dog and use up to $3,000 in losses to offset ordinary income. You can carry forward losses of more than $3,000 to future years.

The IRS allows four different methods for figuring gains or losses on sales or exchanges of fund shares. Before you sell, you should choose a method because your results can vary significantly, as shown in Figure. For example, selling 100 shares of the Vanguard 500 Index Fund purchased between 1999 and the end of 2003, your tax bill can vary from zero to $427.11. If you use a personal finance tool, such as Quicken or Microsoft Money, you can export your mutual fund transactions into a spreadsheet. Using that data, you can calculate the tax bills for each of the methods and choose the one that meets your needs.

Each method of calculating gains produces a different tax bill

After you select a method for an investment, you must use that same method for every sale of that investment.

Average cost per share method

Most mutual fund companies use this method when calculating your gain or loss. Average cost divides the total amount invested by the total number of shares. You calculate your gain by subtracting the average cost per share from the price at which you sold. Record-keeping is easy, so this is the preferred method if taxes aren't a big issue for you.

Double category method

A similar approach to average cost per share method, except that short-term and long-term purchases are separated. Average long-term cost is the total amount invested in shares held more than one year divided by the number of shares held for more than one year. Average short-term cost is calculated in the same way using number of shares and dollars in shares held less than one year.

With the long decline in share prices over the period in this example, the double category method results in a significant loss selling long-term shares, but the largest gain selling short-term shares.

First in first out method

An inventory method in which the first shares bought are the first sold. Because shares held the longest often have the lowest cost basis, this method can lead to the largest capital gains. The IRS assumes you use this method if you don't specify one on your tax return.

Specific shares

You can choose the shares you want to sell to produce the tax results you want, such as the smallest capital gains. The record-keeping burden for this method is painful but can lead to significant reductions in the taxes you pay.

Amy Crane and Bonnie Biafore

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