Caveat for Investors Follows New Tax Rule

Now that mutual fund investors get to see how much taxes eat into their investments, they might wonder just how much Uncle Sam should factor into their buying and selling.

Investors should realize taxes can take quite a bite out of a fund’s overall return, financial experts say. But shareholders shouldn’t yield investment decisions entirely to the tax collector.

Taxes on mutual fund gains are always a big issue at this time of the year, when investors receive end-of-the-year statements from fund companies. Those statements show the amount of capital gains the fund had when securities were sold during the year; each fund investor must pay federal tax on those gains.

But taxes are of particular interest this year because of rules adopted earlier this month by the Securities and Exchange Commission, mandating that mutual funds disclose in their prospectuses and annual reports the estimated one-, five- and 10-year returns after taxes.

The returns have to be shown in two ways: estimated taxes for investors who sell their shares and for those who hold onto the fund. Previously, mutual funds were required to disclose only the returns made before taxes.

An estimated 2.5% of an average fund’s return now goes to taxes, but many investors don’t know that. That’s about 1% greater than the average fund management fee.

“This will begin to awaken people to the fact that they don’t have to pay all these taxes every year,” said Ralph Scearce, a financial advisor and head of Cambridge Financial in Lexington, Ky. Taxes “can make a whale of a difference.”

The impetus for the new rules is the belief that information on taxes will help investors compare the more than 7,000 funds in the market.

Not all funds or portfolios are affected. There are no taxes on funds held in tax-sheltered accounts such as 401(k) retirement plans.

One criticism of the new rule is that it overstates the effect taxes have on funds. The tax-disclosure rule requires funds to calculate the tax effect at the maximum individual federal income tax rate of 39.6%--a worst-case scenario.

The Investment Company Institute, a mutual fund lobbying group, opposed this part of the rule, arguing that the maximum tax rate does not apply to most fund investors.

Institute spokesman John Collins first accentuated the positive: “We believe [the new rule] is completely consistent with improving and strengthening the information that shareholders need for deciding among funds.

“We also pointed out, though, that we think the rate of 39.6% is not the best rate [for illustration purposes]. . . . To be in the 39.6% tax rate, a couple would have to have taxable income of more than $288,000 a year.”

The median annual income of mutual fund investors is $55,000, according to the ICI.

Although financial advisors say taxes are important, most of them also quote an old investment adage that goes something like “Don’t let the tax tail wag the investment dog.”

In other words, “You don’t want to make an investment decision on taxes alone,” said Vernon Lee, who runs Lee Investment Consulting in Raleigh, N.C.

Lee recommends that investors look at taxes to get an idea about the fund manager’s investment style. A higher tax rate would indicate that the manager makes frequent trades and therefore incurs more capital gains.

“That is one of the downfalls of mutual funds,” Lee explained. “You can’t really control your taxes. You are at the mercy of the fund manager’s rate of turnover of the portfolio.”

Lee also recommended that investors treat taxes as a sort of tiebreaker: If an investor is weighing two growth funds, the fund with the smaller tax bill has an edge if other issues, such as performance, fund manager style and fees are the same.

“If they are sort of equal in your eyes,” he said, “the fund that gives you the better tax efficiency is going to win out.”