When capital gains cause royal pains Phantom income doesn't elude the IRS

Mutual funds

July 12, 1998|By Jerry Morgan | Jerry Morgan,NEWSDAY

Are tax-efficient funds important for investors?

Jean and Joseph Wallman of Centerport, N.Y., think so. They expected to pay capital gains taxes earned last year on shares they sold. But, as a retired couple living on a pension and investments, they weren't ready to pay taxes for shares their fund manager sold.

The result was a tax bill a few thousand dollars higher than expected.

"We weren't prepared to pay that much in tax," said Jean Wallman. "We had to sell other funds this year just to pay that tax, which means we will have more capital gains taxes next year. And our accountant now says we may have to make allowances for estimated tax payment this year so we don't underpay our taxes" and face an IRS penalty.

The general lack of concern that fund managers show about the tax consequences of their investment policy is legendary, yet understandable. Performance is the first thing they, and most shareholders, care about.

"Fund managers want high performance," said Don Phillips, president of Morningstar, a Chicago mutual fund ratings firm, "because they are paid to manage for performance and they don't really care about tax efficiency. The capital gains taxes just get passed on [to investors]. The managers buy and sell stocks when they think they should."

But that shifts control of the investor's tax bill to the manager. You may not have sold any shares last year, but you still can get hit by taxes if your fund manager did.

Do shareholders care about capital gains taxes passed on to them if their funds are doing well? They do at tax time, said Rockville Centre, N.Y., accountant Ed Slott. "We had nothing but complaints in March and April, because people had to pay $5,000 or $6,000 in capital gains taxes on phantom income."

Phantom income means that fund shareholders don't see the money because they automatically reinvest it, but it also means they have to come up with the tax money out of pocket.

They could get a check from the fund, pay the taxes and reinvest the balance, but that is inconvenient, and could cost money if the fund has a front-load commission.

So what are tax-efficient mutual funds? Basically, they are funds that make few if any taxable distributions during the year. Funds are required to pass through to shareholders any capital gains and dividends. The trick, if you want to be tax-efficient, is not to have any capital gains.

That can be accomplished several ways. A fund manager can offset capital gains from the shares of stocks that have appreciated by selling shares that have lost money. Or a fund can have low turnover, which generally creates long-term unrealized capital gains instead of quick taxable profits. Or a fund can have a mix of taxable stocks held long-term and tax-free municipal bonds, which is how several tax-efficient funds are structured.

But performance is still the driver, and there is a growing reason for it: the huge flows into tax-advantaged accounts such as 401 (k)s and individual retirement accounts.

The issue is, if there is so much fund money in tax-deferred accounts, why bother to tax-manage a fund in which the majority of shareholders don't pay taxes?

"We are on the verge of class warfare," said Geoff Bobroff, a mutual fund industry consultant in East Greenwich, R.I. "Everyone wants to see double-digit returns, but the goals of the two groups of investors separate. I may want minimum tax exposure, but the tax-deferred investors are saying put the pedal to the metal, load it up. I think you may see some fund splitting along those [tax-deferred vs. taxable] lines."

High returns and no tax bills can be combined. Morningstar found 11 U.S. diversified funds and four emerging-markets funds had returns of more than 30 percent and no distributions last year. Nineteen tax-managed funds also had returns of 20 percent or more in 1997.

But in a year when the average equity fund returned 24 percent with a wide range of distributions, there aren't many tax-efficient funds among the 7,000 out there.

Does that mean you should rush out to buy tax-managed funds? Not necessarily. "I think investors should run away from tax-efficient funds now because their returns aren't as good as other funds," said Michael Lipper, president of Lipper Analytical Services Inc.

Pub Date: 7/12/98

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