Taxes can really eat into your returns

Your funds

Your Money

April 30, 2006|By CHARLES JAFFE | CHARLES JAFFE,MARKETWATCH

Most Americans are happy at this time of the year to think that they're done paying taxes for a while. But if 2005 was any indication, fund investors are only just beginning to pay Uncle Sam, and the damage is about to get a lot more noticeable.

According to a study from Lipper Inc., estimated taxes paid by fund investors in 2005 were up 58 percent from 2004, with investors losing more than $15 billion to the government due entirely to mutual fund payouts.

When next tax season comes around, Lipper senior research analyst Tom Roseen believes that taxes will be an even bigger drag on fund performance than expenses are, especially in fixed-income funds. And with roughly half of the $8.4 trillion invested in funds held in taxable accounts, the odds are pretty good that average investors are in for a tax pinch at some point.

Under most circumstances, investors worry about "asset allocation," but the Lipper study shows that "asset location" could be every bit as important, so that tax-efficiency becomes a factor in portfolio design decisions. The basic idea - one that the Lipper study suggests many people ignore - is that funds that generate the biggest tax obligations should be put into tax-deferred accounts.

"No one should make tax-efficiency their first factor in deciding which funds to own," says Roseen, "but it should be a tiebreaker in making a choice, and it's important for investors to make sure that the funds they're looking at truly belong in the kind of account they're going into."

Mutual funds are "pass-through securities," meaning that any tax obligations the fund incurs get passed on to investors, who are then responsible for paying any taxes due. Most individual investors simply roll distributions back into the fund; unless they hold the fund in a tax-deferred account, they owe taxes on those gains and dividends, even if they never touch the cash.

Since 2002, mutual fund prospectuses have had to show after-tax returns, but most investors have heretofore ignored the data, if only because the payouts were muted by past losses.

By the time 2005 rolled around, most of those tax-loss carry-forwards had been exhausted, and there was no cushion to protect shareholders from the trading profits recognized by their fund managers.

Roseen notes that most people don't recognize just how big the tax effect really is. Because most distributions are rolled back into the fund, investors don't see their fund accounts shrinking by the dollars being sent to Uncle Sam.

"If taxes eat up one-fifth or more of your return, it's going to have a big long-term impact on your ability to reach your goals. Put it together across your whole portfolio and you can lose the compounding effect by not paying attention to the taxes."

Roseen and others suggest investors use tax efficiency to decide the best place to hold a fund. Traditional advice has been to put fast-growing funds into tax-deferred accounts, but with the government having cut the capital gains tax rate, many financial advisers now suggest that income-oriented funds may be a better choice, because the flows get taxed at higher ordinary income-tax rates, rather than as capital gains.

Ultimately, the idea is to put inefficient funds in tax-advantaged accounts, and to put funds that work to minimize tax bills in accounts where that detail will save you money.

jaffe@marketwatch.com

Charles Jaffe writes for MarketWatch. He can be reached by mail at Box 70, Cohasset, MA 02025-0070.

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