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Investors' gains have a likely downside at year-end
Investors with mutual funds in taxable accounts might be in for a year-end surprise.
Each year, funds must distribute dividend income or capital gains earned on the sale of securities to shareholders so that they can be taxed on it. This hasn't been much of an issue in recent years. Funds have had losses from the bear market to offset subsequent capital gains, minimizing the tax bite for shareholders.
"We have been on a tax holiday of sorts," said Tom Roseen, a senior research analyst at Lipper Inc.
But the holiday is ending, Roseen said. Funds have fewer losses left to offset gains. And many funds have enjoyed "phenomenal returns," he said. The bottom line: Investors can expect more capital gains to be passed through to them this year.
The tax bill has been growing. Investors in stock funds paid $15.2 billion in taxes last year on capital gains and dividend income, Lipper estimated. That's 58 percent more than in 2004.
Investors will find out their potential tax liability soon as fund companies start to give investors a heads-up on capital gains, which usually are distributed in December.
Some financial planners say the capital gains aren't a bad thing. They're usually a sign that the fund is doing well. And the tax rate on long-term capital gains--profits from securities that have been held for at least a year--has been cut to 15 percent for many investors. Stock dividends, too, generally are taxed at 15 percent.
Taxes shouldn't be the main factor when choosing a fund. The type of fund, its performance, management and expenses are important considerations. But some fund experts say investors too often overlook the impact of taxes.
Consider that investors in stock funds on average gave up 1.6 percentage points of their annual returns to taxes over the past decade, Roseen said. Bond fund investors forfeited an average of 2.4 percentage points to taxes.
"Compound that for 30 years ... and that is a large amount of money," Roseen said.
If you like the diversification offered by funds but are concerned about taxes, here are some suggestions for investing in taxable accounts. Investors with tax-deferred accounts, such as 401(k)'s or traditional individual retirement accounts, don't have to worry about gains now. They will be taxed when taking withdrawals.
-- Index funds. These tax-efficient funds attempt to mirror a benchmark, such as the Standard & Poor's 500, by buying shares in the companies that make up the index. Indexes don't change their composition very much, so turnover is low. And low turnover means fewer opportunities to generate capital gains.
-- Exchange-traded funds. These are similar to index funds but potentially more tax-efficient. With a traditional mutual fund, all shareholders could receive capital gains passed through to them if, say, the fund was forced to sell securities to cash out an institutional investor or a large number of individuals.
But an ETF's structure allows it to shelter the rest of the investors in the fund from capital gains when others pull out. Any capital gain ultimately is recognized by the investors leaving the ETF.
It's possible, though, that an ETF will pass on capital gains to all investors. For instance, if one company is dropped from the index, the ETF would be forced to sell the stock and the gains could be passed through to shareholders, said Sonya Morris, senior mutual fund analyst with Morningstar Inc.
Unlike traditional funds, ETFs can be traded throughout the day, like a stock. That's a convenience, but frequent trading can pile up transaction costs and trigger short-term capital gains. Gains on securities held for less than a year are taxed at an investor's ordinary income tax rate, which can be as much as 35 percent.
"If you had the most tax-efficient ETF in the world, you can erode that tax efficiency by trading frequently," Morris said. -- Tax-managed funds. These funds use various strategies to minimize taxes. For instance, they time the sale of securities to best offset winners with losers. And they tend to have low turnover in fund holdings.
"You have to take a long time horizon and develop a holding period of five years to forever," said Duncan Richardson, chief equity investment officer with Eaton Vance Corp., which offers tax-managed funds.
Investors can compare funds' tax advantages. All mutual funds must report their after-tax returns in the prospectus. Morningstar also offers a tax analysis on its Web site, www.morningstar.com. Plug in a fund's ticker symbol, click on tax analysis and you'll find the tax-adjusted return plus a tax-cost ratio.
Fidelity's Magellan fund, for instance, has a tax-cost ratio of 1.43 percent over three years. That means, on average, Magellan investors gave up 1.43 percent of their assets to taxes each year. The largest index fund, the Vanguard 500, has a three-year tax-cost ratio of 0.31 percent. Eaton Vance's Tax-Managed Growth fund has a ratio of 0.15 percent. Some other funds try to minimize taxes, too, although that's not their specific goal, Morris said.
But if you have your heart set on a fund that throws off high capital gains, hold the fund in an IRA or other tax-deferred account, she said.
Also, if you plan to invest a sizable lump sum in a mutual fund soon, you might want to wait until the fund makes its capital gains distribution, said Ellen Rinaldi, a principal with the Vanguard Group. That way, you won't own the fund for a short time and then be hit with the tax, she said.
Eileen Ambrose is a columnist for The Baltimore Sun, a Tribune Co. newspaper.