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Planning Can Reduce Mutual Fund Tax Bite

It’s almost time for mutual funds to begin making their annual taxable gain distributions — and the perfect time to begin planning how to minimize their tax bite on your 2001 return.

Mutual funds are required to distribute 90% of the taxable income earned during each fiscal year. When the funds are held in taxable accounts, these distributions are taxable whether or not the investor elects to reinvest dividends and capital gains, and can have a substantial effect on a portfolio’s after-tax rate of return.

Mutual fund distributions come in two forms, income and capital gains. Income distributions are taxable to investors at their ordinary federal income tax rates, currently 39.1% for those in the highest bracket. Capital gains distributions reflect gains that the fund realized on positions held for more than one year, and are taxed at the current long-term rate of 20%. Some mutual funds also report "short-term gain" distributions, but these are treated as income distributions, not as capital gains. This means short-term gain distributions from a mutual fund cannot be offset against capital losses if, for example, you have sold stocks that fell during the market downturn.

To avoid being hit with a large taxable distribution, it is important to understand why funds make those distributions. When a fund manager sells a position in an underlying investment, i.e., a stock or bond, he or she realizes either a gain or loss on the sale, depending on the investment’s cost basis. In a portfolio of stocks, at any given time some positions will have unrealized gains and some will have unrealized losses. This means that when you buy into a mutual fund, it will have an embedded gain or loss. If you recently bought into a fund that is about to make a distribution, and that realized large gains earlier in the year, you may be forced to pay substantial taxes on appreciation from which you never benefited. In this case, it may have been wiser to have waited to purchase the fund until after the record date, which is the cutoff date for determining shareholders who will receive the distribution.

Last year was a very bad year for distributions, as mutal fund companies paid out a record $325 million in capital gain distributions, according to the Investment Company Institute. Figure 1 displays the funds that paid out the largest percentages of their net asset values (NAV) in 2000.

Fund Capital Gains Distributed (% of NAV)

UAM Sterling Partners Equity (STEQX)

96%

Credit Suisse Instl Value (WPIVX)

91%

Standish Small Cap Equity (SDSCX)

89%

CMC Small Cap (COSCX)

70%

Delaware Pooled Mid-Cap Growth Equity (DPAGX)

62%

PIMCO International Growth (PIGIX)

62%

Westcore Midco Growth (WTMGX)

61%

Dresdner RCM Midcap (DRMCX)

57%

Nicholas-Applegate Mini-Cap Growth (NAMCX)

57%

Nicholas-Applegate Pacific Rim (NAPRX)

56%

Figure 1 Data courtesy of Morningstar, Inc.

Watch For Warning Signs

Last year’s record distributions are a result of many funds having great appreciation in their holdings during the late ‘90s bull market. When the market turned sour in 2000, some of those funds were forced to sell highly appreciated stocks to meet shareholder redemptions. When a hot fund has attracted a lot of assets from performance-chasing investors and subsequently faces massive shareholder redemptions as market sentiment changes, it is a warning sign that the fund will have a large distribution.

Other warning signs that a fund will pay a large distribution are manager or strategy changes. When a new manager takes over the portfolio, he or she often realizes gains while tailoring the portfolio to his or her investment style. When a fund changes its strategy, it has to rework the portfolio to meet the characteristics of the new investment approach.

At Palisades Hudson Asset Management, Inc., we use a variety of strategies to minimize our clients’ realized gains and maximize their total after-tax return.

The simplest way to avoid capital gains distributions is to not be subject to them in the first place. To accomplish this, call your fund company in early November, before most funds make their distributions, and ask whether it can estimate what the distributions will be. Most companies will provide estimates, and some post them on their Web sites.

If you are facing a large distribution in a holding in which you have a loss, sell it before the record date and reap the loss. This strategy is referred to as tax-loss selling. Capital losses can be used to offset capital gains, and to the extent losses exceed gains, they can be used to offset up to $3,000 in ordinary income. Any capital loss not used in that tax year will be carried forward indefinitely, so you can eventually get the tax benefits of realized losses.

Keep Portfolio Balanced

However, while you are tax-loss selling it is important to maintain the proper asset class exposure. You should replace the funds that you sell with comparable funds to avoid missing significant moves in the stock market. After 30 days (to avoid the IRS’s 30-day wash-sale rule, which disallows losses if the same investment has been purchased within 30 days of when you sold it) you can re-evaluate the replacement fund and either repurchase your original holding or continue with the new fund. Either way, you have kept your portfolio in line with its target asset allocation without triggering substantial taxes.

If you have a gain in a fund that is expected to have a large distribution, consider selling the fund in order to realize a larger long-term gain that is taxed at a lower rate than ordinary income. Realizing the gain will often make sense when you have held the fund more than one year, and the fund expects to make a large short-term gain distribution.

Investing in tax-efficient mutual funds can reduce end-of-year tax surprises. Generally, the way to judge whether a fund is tax-efficient is by the portfolio’s turnover ratio. It describes how often the fund manager sells positions in the portfolio. A turnover ratio of more than 100% is high. Look for a fund with very low turnover, which means the fund is not realizing a lot of gains.

Index funds tend to be more tax-efficient than actively managed funds because they implement a buy-and-hold strategy that results in very low turnover. This is evidenced by the fact that the Vanguard 500 Index fund has distributed only 0.41% of its NAV in capital gains annually on average for the five years through 2000. Compare this with the actively managed Fidelity Magellan fund, which distributed approximately 7.65% of its NAV annually over the same period.

When searching for tax-efficient funds, understand the fund manager’s investment philosophy and read the prospectus to see whether the fund manager tries to minimize realized gains. Many funds perform tax-loss selling to benefit their investors, while others focus solely on maximizing pre-tax return. The fund’s annual report provides a balance sheet that will list the fund’s total unrealized gain or loss, which lets you know what you are buying into. Also, take a look at what percentage of NAV has been distributed in recent years. This will give you an idea of how tax-efficient the fund is.

Nonetheless, it is important to remember not to let taxes be the driving force behind your investment decisions, but rather a factor in your overall analysis. Attractive investments may be tax-inefficient. In these cases, try to keep them in tax-deferred accounts, such as an IRA or your company’s 401(k), so you still get the great return without losing a chunk to taxes.

The moral of the story for mutual fund investors is: Be prepared. Knowing the tax consequences of an investment decision, and planning accordingly, can prevent Uncle Sam from taking as much as a 40% bite out of your return.

Vice President Eric Meeermann, who is based in our Stamford, Connecticut office, contributed several chapters to our firm’s book, Looking Ahead: Life, Family, Wealth and Business After 55, including Chapter 11, “Social Security And Medicare;” Chapter 18, “Philanthropy;” and Chapter 19, “A Second Act: Starting A New Venture.”

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