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No topic is more eye-glazing than mutual-fund taxation. But you ignore it at your peril.

Just ask Jeff Cohen. A 45-year-old executive at a chain of tutoring schools in New York, Cohen decided in July he had stood on the bull market's sidelines for too long. So he switched his taxable portfolio out of municipal bond funds and into an assortment of 15 funds. Now, he's kicking himself--and not just because the market has sunk. He reckons he'll owe more than $5,000 in taxes on distributions he expects from the new funds, including some on which he has paper losses. ''I'm saying, 'What a stupid person you were!''' Cohen says. ''But it just didn't click.''

Given the wicked complexity of funds and taxes, he has plenty of company. The problem stems from a requirement that funds pass along to investors each year their share of the capital gains or losses, plus any interest or dividends. So you pay taxes if you make a profit from selling your shares. But you're also liable for taxes on your portion of the gains realized by the fund's portfolio.

Because the strong market has triggered big gains in funds this year, the funds will be making fat distributions. Even if you bought your shares late in the year and have lost money, you'll get the full distribution--taxable to you--while seeing your share price drop by that amount. Ouch.

Let's say a fund is worth $20 a share before paying $3 in gains and dividends. You'll wind up with shares worth $17 each and a tax liability on the $3 in distributions. That's true whether your fund shares are up, down, or sideways since you invested, and whether you take distributions in cash or reinvested shares. (The exception: funds held in individual retirement accounts, 401(k)s, or other tax-protected accounts.)

What can you do now? And how might you get the best aftertax returns? If you're in Cohen's shoes, Stanford University economist John Shoven suggests that you consider selling your underwater shares before the fund pays its dividends and distributions. (You can call your fund company to learn the planned record date.)

That way, you'll create a capital loss, which may be handy elsewhere on your return--and you'll sidestep the taxable distributions. The risk is you'll be uninvested while waiting the 31 days until you can repurchase shares in the same fund without breaking the ''wash-sale'' rule, which would invalidate your capital loss. But look around: You might be able to find a comparable fund that has already made its distributions.

Next time you go fund shopping, search for managers and fund families that have proved sensitive to shareholders' tax bills. To this end, while the information is not required by law, it never hurts to ask whether the manager has a big stake in the fund. Those who do, such as Third Avenue Value Fund's Martin Whitman, are loath to run up their own taxes by realizing capital gains prematurely.

SHOP AND COMPARE. You also can check fund-advisory services, such as Morningstar (800 735-0700) and Value Line (800 634-3583). Morningstar reports funds' average tax-efficiency--the ratio of aftertax returns to pretax total return over 3, 5, and 10 years. In the three years ended Sept. 30, the average domestic stock fund's aftertax return was a bit under 89% of its pretax return. Third Avenue Value? More than 95%. The latest version of the Value Line Mutual Fund Survey software has a nifty feature that shows how much money you would have wound up with in any fund, after taxes, given a host of variables--from your tax rate to how much you invested when. And since 1994, BUSINESS WEEK's yearly mutual-fund Scoreboard has been showing average annual total returns both on an aftertax and pretax basis for 1, 3, 5, and 10 years.

Think about investing in one of the ''tax-aware'' funds, a no-load sampling of which appears in the table. These make maximizing their shareholders' aftertax returns a key objective, a departure from most managers' preoccupation with pretax results, which set many salary bonuses. Tax-aware funds keep tax bills low by picking no- or low-dividend stocks, while the balanced funds stick to a mix of such stocks plus tax-free municipal bonds. In addition, these funds take pains to consider the tax effect of each trade, and they search for losses in the portfolio that can be ''harvested'' and used to offset any taxable income or gains from other trades.

One caution: Many of these funds carry early-redemption fees to discourage short-term holders whose in-and-out trading makes it harder for the fund to avoid realizing gains. That's a quirk Cohen is examining as he ponders investing in a tax-aware fund. ''You have to pay attention,'' he says. Mutual-fund taxation ''really is one of those little black holes.''

Robert Barker

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Updated Nov. 6, 1997 by bwwebmaster
Copyright 1997, Bloomberg L.P.
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