Some ways to keep the taxman from inflicting pain

PERSONAL FINANCE

Dollars & Sense

January 07, 2001|By EILEEN AMBROSE

Mutual fund owners last year were dealt a double-dose of pain. Not only did many see the value of their fund sharply reduced, but they also may end up owing capital gains tax on appreciated securities sold by the fund earlier in the year.

Worse yet, the pain may not be over.

"A lot of people assumed they would be able to sell holdings to pay their tax bills, but now may be selling in a down market," said Matthew Hitt, a Towson accountant. "It will be a difficult tax season for a number of people."

Mutual fund investors in recent years have tended to overlook the tax consequences of their investments, satisfied with returns of 20 percent or more year after year, experts said. Fund managers, who are often compensated based on their pretax returns, frequently ignore the impact of taxes, too, experts said.

But taxes eat away at returns and should be factored in as part of the cost of mutual funds, some argue.

The Securities and Exchange Commission agrees. Last year, the agency proposed that all mutual funds be required to report after-tax returns to raise investors' awareness of the tax consequences and to show that some funds are more tax-efficient than others.

Just how costly can taxes be?

Taxes on dividends and capital gains can be blamed for lowering the return of the typical U.S. stock fund 2.5 percentage points each year over the past decade, said Joel Dickson, a tax-efficiency expert for the Vanguard Group, the mutual fund company in Malvern, Pa.

Bond and money market funds can be even more adversely affected because the gains they slough off tend to be taxed as ordinary income, which for many investors is a higher rate than the top long-term capital gains rate of 20 percent, he said.

So, what can investors do to develop a tax-efficient portfolio? Experts suggest:

Begin by choosing stocks and funds to hold for the long term, rather than trading investments frequently and incurring taxable gains, said Russel Kinnel, director of fund analysis for Morningstar, the mutual fund tracking company in Chicago.

By owning individual stocks, investors - rather than a portfolio manager - control their tax bite because they decide when to realize gains or losses, experts said. But small investors may not have enough money to acquire a well-diversified stock portfolio and find they're better off with a mutual fund.

Buy low-fee index funds, Hitt said. These funds try to mirror the performance of a particular benchmark, such as the S&P 500 index, and, unless the stocks in the index change, the fund won't be switching securities and possibly recognize gains, he said.

Consider a tax-managed fund, which tries to limit taxes. Such a fund might invest in companies whose stock it wants to hold for a long time, thus postponing gains, or it buys stock in companies that don't generate high dividends. When trading, tax-managed funds will sell losers to offset the gains in winners.

Vanguard, which offers five tax-managed funds that have never had a capital gains distribution, takes another precaution, Dickson said. It charges a redemption fee for those who sell their shares within five years to discourage short-term trading that could potentially force the fund to sell securities and realize gains.

There are now 59 tax-managed funds, and most large fund families now offer them, Kinnel said. Baltimore's T. Rowe Price Associates added its third tax-managed fund late last month. "The important thing about tax-managed funds is just about all of them have beaten their peer group after taxes," Kinnel said.

Reinvesting dividends helps build a nest egg, but investors would be better off if they directed dividends from a tax-inefficient fund into a fund that's tax-efficient, Dickson advised.

Consider exchange-traded funds that feature characteristics of a fund and individual stock, said Scott Hamill, national director of sales and marketing for KPMG Investment Consulting Group in Baltimore.

With exchange-traded funds, investors buy shares of a basket of securities, which often tries to mimic an index and limit turnover. These shares are bought and sold just like individual stocks, giving investors more control over when they take gains, Hamill said. Exchange-traded funds generally have low management fees, too.

The downside is that investors pay a brokerage commission each time they acquire shares, which can add up for those making regular small investments over many years, some experts said.

Take advantage, if eligible, of tax-friendly retirement accounts, such as a 401(k) or Individual Retirement Account, Hitt said. With a 401(k), for instance, contributions reduce current income taxes and the investments in the account grow tax-deferred.

Those eligible for a Roth IRA invest money that's already been taxed, but the gains in the account can be withdrawn tax-free years later at retirement.

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