Want Less Capital-Gains Tax Pain? Some Tips to Cut Your IRS Payment

It’s enough to drive you crazy. Or in Sharon Flood’s case, enough to drive her away from mutual funds.

Last year, when Flood sat down to do her taxes, she noticed something odd. Something infuriating. Though her fund, American Century-Twentieth Century Vista, lost money in 1997--it was down 8.7%--she still received a tax bill for the capital gains the fund distributed at the end of the year.

“It just kills you,” says the Mission Viejo mother of three, noting that the money she shelled out in taxes was money she could have invested for her kids’ college educations.

“If your fund is doing well, maybe you don’t feel as bad about the taxes,” Flood says. “But when the fund is losing money, and you still have to pay taxes on it, it’s just frustrating.”

Which leads Flood to conclude this year: “From a tax standpoint, it might be better for me to hold the stocks directly” and to bypass funds altogether.

It’s a sentiment shared by a growing number of investors whose funds underwhelmed or lost them money last year--especially on an after-tax basis. (Money in tax-deferred accounts don’t have this problem, of course.)

But is investing in individual stocks your only recourse? Absolutely not. Before you turn to self-management, you might want to consider some of the following tax-efficient strategies:

* Consider a ‘tax-managed’ fund. There are now at least 46 self-described tax-efficient stock mutual funds to choose from, according to Chicago fund tracker Morningstar Inc. That’s more than twice the number that existed two years ago. And there are dozens of others that are de facto tax-efficient funds, though they don’t market themselves as such.

How do these funds achieve tax efficiency?

Well, if the fund decides to sell a stock it has owned for, say, 360 days, it might hang on for a week longer to ensure that profits on the investment are taxed as less expensive long-term capital gains rather than as short-term gains.

Or if the fund wants to sell a winning stock, it might simultaneously sell a losing stock in the portfolio to match up--and therefore offset--gains with losses.

“A lot of it is just common sense,” says Mark Stumpp, co-manager for the recently launched Prudential Tax-Managed Equity fund.

You’d think that all fund managers would be cognizant of the tax implications of their buy and sell disciplines--and would act accordingly.

“You’d hope so,” Stumpp says. “But many managers are compensated purely in terms of their gross [pretax] performance. They could care less about tax efficiency.”

OK, but won’t a fund’s after-tax returns depend largely on its performance? In other words, what good is a tax-efficient fund that’s horrible at stock picking?

Not much. But a just-released study by the consulting firm KPMG determined that historically, tax-efficient funds have performed better than general-purpose domestic stock funds, based on pretax and after-tax returns over the 10 years through Dec. 31, 1997.

Two names to consider: Vanguard Tax-Managed Growth and Income ([800] 662-7447) and T. Rowe Price Tax-Efficient Balanced ([800] 638-5660).

* Try a low-turnover fund. The term “turnover” refers to the rate at which a fund replaces its holdings.

For instance, the average stock fund has a turnover rate of nearly 90%, which means that every year, it tends to sell nearly every stock it owns and buy new ones.

Obviously, the higher a fund’s turnover rate, the more frequently it sells stocks. And the more frequently a fund sells stocks, the greater the likelihood it will realize capital gains--which eventually get distributed to shareholders.

You can look up a fund’s turnover rate at Morningstar’s Web site (https://www.morningstar.net).

Solid performers with low turnover rates include Legg Mason Value Trust ([800] 577-8589), Transamerica Premier Equity ([800] 892-7587), White Oak Growth Stock ([888] 462-5386) and Papp America-Abroad ([800] 421-4004).

* Try an index fund. Such passively managed funds simply track the Standard & Poor’s 500 index of blue-chip stocks or the Wilshire 5,000 total stock market index or some other market yardstick. Funds tied to indexes such as these, whose composition changes infrequently, are by definition low-turnover portfolios. That’s because they simply buy the stocks in their respective indexes and hold them until the stocks are removed from the index.

Some funds to consider: Vanguard Index 500 ([800] 662-7447), Schwab 1,000 ([800] 435-4000), Fidelity Spartan Total Market Index ([800] 544-8888) and the newly launched Wilshire 5,000 Index ([888] 200-6796).

It’s important to note, though, that by investing in an index fund--or in any low-turnover fund for that matter--you aren’t escaping taxes.

“All you’re doing is pushing the taxes off,” says Costa Mesa financial planner Glenn Woody. Indeed, when the fund sells stocks (for instance, in the event of mass shareholder redemptions, an index fund would have to sell shares to meet those redemptions), it will realize long-term capital gains built up in the portfolio. The gains will then be distributed to shareholders.

* Consider SPDRs or Diamonds. SPDRs (pronounced “spiders”) are Standard & Poor’s depositary receipts, and Diamonds are Dow Jones industrial average model new depositary shares.

These are unit investment trusts whose shares are traded like stocks on the American Stock Exchange and can be thought of as ready-made portfolios consisting of all the stocks in the S&P; 500 or the Dow industrials, respectively. These securities, like index funds, give you exposure to all the stocks in an index. And their expenses are extremely low.

Yet, owning shares of a SPDR or a Diamond may be more tax-efficient than owning shares of an S&P; 500 index fund because SPDRs and Diamonds don’t realize--and, therefore, distribute--capital gains to shareholders as much as index funds do. To be sure, investors must still pay taxes on profits once they sell their shares and on dividend income thrown off by the stocks in the trust.

Another advantage to owning shares of SPDRs or Diamonds? You can buy and sell shares based on intra-day prices, whereas funds will allow you to do so based only on closing prices.

A similar vehicle will be launched this year that will track the Nasdaq 100.

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Times staff writer Paul J. Lim can be reached by e-mail at paul.lim@latimes.com.