Why not tax gains when funds are sold?

Your Funds

Your Money

April 24, 2007|By Charles Jaffe | Charles Jaffe,Marketwatch

If you see a storm coming, you either prepare for it or tough it out.

Look closely enough at some fund statistics published last week by Lipper Inc., and it's hard to ignore the possibility that investors are facing a storm likely to catch them both unaware and unprepared.

The building storm is evident in the trend of rising tax dollars paid by investors to Uncle Sam. According to Lipper, investors in taxable mutual funds paid the government at least $23.8 billion in 2006, simply for pursuing a buy-and-hold strategy.

Mutual fund distributions for 2006 were at their highest level since 2000. That was the year when investors got flooded with payouts on funds that lost money, paying a hefty bill while suffering a downturn.

Now the fund world seems inexorably drawn to that miserable combination of events again.

Mutual funds are "pass-through" investments, meaning that the tax obligations of the fund are passed to shareholders, who are on the hook for them. If a fund accrues capital gains by trading stocks, shareholders must pay the tax man for their share of the gains. (By comparison, an investor in an individual stock owes capital gains taxes only when he sells his shares at a profit.)

There are worse things than receiving taxable distributions, such as losing money. But taxes are a drag on taxable accounts, which is why investors might look for "tax-efficient" funds to hold there.

The looming problem comes from gains piling up over time inside a fund when the market is hot. When the stock market turns, managers close out long-term winners to lock in profits, creating a situation like 2000, when the bear market arrived, funds suffered big losses, but then paid out huge taxable distributions as an extra kick in the pants.

"I think people have forgotten how bad that was," says Tom Roseen, the Lipper senior research analyst behind the tax study. "Capital gains rates are lower now, and people are thinking there just won't be the same kind of problem again."

In 2002, lawmakers forced mutual funds to make investors aware of tax efficiency. It might have had an effect on investor behavior if average consumers read their prospectuses closely.

They don't.

With four years of outstanding performance, the stock market has racked up big gains, and a lot of those profits have not been realized, despite the increasing distribution trend highlighted by Lipper. If the market takes a downturn and managers sell positions to protect their profits, the distributions paid out will dwarf current numbers. And there won't be nice market gains to keep investors cheery.

Of course, investors in taxable accounts might be unhappy just with taxes they paid on distributions in 2006, if they paid attention to their real impact. Roseen's study showed that the tax drag on many types of funds is more than double the fund's expense ratio; over time, that kind of tax bite can significantly eat into returns.

That's not a reason to put the tax-efficiency factor first in deciding which types of funds to buy, but it should make investors think about which kinds of funds they want to own in a taxable account. It should make taxes a tie-breaking factor in deciding which of several funds is the best fit for a portfolio.

The whole situation could be made a lot more simple if Congress would step up and embrace a bill that would allow investors to avoid capital gains taxes on their funds until they sell their shares, essentially treating funds more like stocks.

The proposal would save investors a bundle and has bipartisan support, but it doesn't appear to be gaining steam. The Lipper study will help, but chances are that Congress won't take action until there is another confluence of market losses and gains payouts to anger investors.

And if that confluence doesn't happen for a few years - if the market can avoid the downturn and managers let gains continue to build - there's the prospect of a "perfect storm" in 2010, when capital gains rates could be going back up, increasing shareholder pain.

jaffe@marketwatch.com

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

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