Before Investing, Check Tax Status of Payouts

The little American Growth Fund of Denver paid out $1.56 a share in capital gains to investors in 1994, a year during which the fund posted a negative return of 4%.

The capital-gains payout reflected prior-year profits on stocks that Robert Brody, the fund’s portfolio manager, unloaded as his market outlook worsened. “Shareholders realize that these distributions come about because we’re making money for them,” he said.

That’s true enough, but it’s never fun to receive a tax bill in a year of low or negative returns--as happened to shareholders in dozens of stock and bond portfolios in 1994. Such payouts during below-par years serve to focus attention on the murky mutual-fund “tax efficiency” issue.

In general, mutual funds don’t do a good job of minimizing capital-gains payouts to investors. The funds themselves don’t pay taxes on gains so they don’t have to worry about them. Rather, it’s the shareholder who pays.

How big is the tax drag over time?

A study conducted by Stanford University researchers Joel Dickson and John Shoven found that $1 invested in a mix of 62 stock funds in 1963 would have grown to a pretax $21.89 by the end of 1992. That figure includes capital-gains distributions and income dividends reinvested along the way.

But for a high-bracket taxpayer who reinvests distributions after paying taxes on them each year, the same stake would have grown to only $9.87.

Perhaps more important, the researchers found that the way individual funds manage potential tax liabilities can greatly affect their performance rankings.

Since many investors buy funds based on these rankings, that’s a concern.

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Unfortunately, it’s hard to find tax-adjusted performance results on individual funds because the numbers are difficult to compute and interpret.

A single fund could generate different tax-adjusted returns depending, for example, on a shareholder’s federal tax bracket and the tax bite of his or her state.

Also, a given fund can be highly tax efficient one year but less so the next. IDS Growth Fund, for example, paid out only 4 cents a share in gains during the strong market year of 1988, but paid $6.98 a share during a flat 1990.

You shouldn’t let tax considerations dominate your investment decisions. “Taken to an extreme, one can avoid all taxes by simply avoiding all profits,” observes Morningstar Inc., a Chicago research firm that provides a tax analysis on the funds it rates.

It can be helpful to pay attention to factors that might lead to a big tax bill, however. Here’s what to look for:

* Unrealized capital gains in a portfolio. Check the fund’s shareholder reports for this information. Unless a fund’s holdings fall in price, the unrealized gains likely will have to be paid eventually. Evaluate them in proportion to the size of the fund.

* Realized and unrealized losses in the portfolio. Such losses can’t be distributed to investors in the form of a deduction or tax credit, but they can be used to offset a fund’s gains down the road, providing a pleasant, if rare, form of shelter. A fund’s reports to shareholders will include these numbers, too.

* Dividends collected on stocks and interest payments on bonds. Funds that generate most of their returns from income rather than appreciation are inefficient from a tax standpoint.

* The timing of income dividends and, especially, capital-gains distributions. Most funds pay the latter once a year, usually in November or December. That’s why it’s often unwise to invest at year-end; you “buy” a full year’s worth of taxable gains. Call the fund group or your broker for details.

* Fund companies that try to minimize capital-gains payouts. Mutual funds often buy and sell shares in a single stock at different times and prices, presenting an opportunity to mix and match transactions so as to lower the tax bite to shareholders.

“When we sell securities we make a conscious effort to release the highest-cost shares first,” said Maryanne Roepke, vice president and treasurer at Twentieth Century Mutual Funds in Kansas City ((800) 345-2021).

The Twentieth Century Growth and Select funds scored high in terms of tax efficiency in the Stanford study.

Certain other funds also pay heed to many of the above factors. Examples include Schwab 1000 and Schwab Small-Cap Index ((800) 526-8600) and USAA Investment Balanced ((800) 382-8722), which takes the simple but unusual tack of holding municipals as its bond component.

Also worth checking are Vanguard’s Tax-Managed Balanced, Capital Appreciation and Growth & Income funds ((800) 662-7447). The Vanguard products pursue a buy-and-hold strategy and sell high-cost shares first. They also impose a small redemption fee to encourage shareholders to sit tight, thereby reducing the need for fund managers to unload shares that might result in a taxable distribution.

Then again, investors can get even better tax deferment by purchasing whichever mutual funds they wish--provided they hold them in an individual retirement account, variable annuity or company-sponsored retirement plan.