02/02/98 UNCLE SAM WANTS YOURS! DON'T MAKE IT EASY FOR HIM

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UNCLE SAM WANTS YOURS! DON'T MAKE IT EASY FOR HIM
The bill is coming due on your fund earnings. Here's how to minimize the tax bite
You may have made a bundle in your mutual funds last year, but don't put a final figure on your bottom line just yet. After three years of spectacular gains, mutual funds made record distributions to their shareholders last year. Most of those payouts were not pocketed by investors but were plowed right back into the funds.
John C. Bogle, chairman of Vanguard Group, estimates that mutual funds as a whole distributed $150 billion in 1997 and that the tax bill for that could be $22 billion. ''People are getting sticker shock as they open their 1099s,'' says Bogle. Only funds held in tax-deferred accounts such as IRAs or 401(k)s avoid the tax. But it's only deferred, not forgiven.
If you get socked with taxable gains for 1997, there isn't much you can do about it now. But you can fine-tune your mutual-fund holdings to minimize the tax burden for 1998--and on into the future.

WHAT WORKS WHERE
In order to minimize taxes and maximize returns, you need an ''asset placement'' plan. Where you hold the assets, either in tax-deferred accounts or regular taxable accounts, can make a big difference in your real returns.
The general rule of thumb has been to put funds that produce current income, mainly bond funds, into your tax-deferred accounts. That's because the income these funds produce is subject to ordinary income taxes--and those rates can be as high as 39.6%. Equity funds, which produce mainly capital gains, should go to the taxable accounts, goes the reasoning, since capital-gains tax rates--especially now--are a whole lot lower. Besides, if you put equity funds in the tax-deferred accounts, the proceeds--even capital gains distributed by the funds--will eventually come out as ordinary income. Why turn low-taxed gains into higher-taxed income?
But some new research points in exactly the opposite direction: Put the equity funds in a retirement account, and hold the bonds, preferably tax-exempt bonds or bond funds, in the nonsheltered account. The reason: The returns on stocks are so much higher than on bonds, therefore the tax deferral on the capital gains that would be distributed is worth far more than the deferral on interest income. ''Tax deferral is like an interest-free loan from the government,'' say Bogle. ''Make the most of it.''
The new approach is a provocative idea, for sure. Back-testing shows this strategy worked well over the last 20 years, but that was a period when equity funds far outpaced the returns from sheltered taxable bond funds. But what about the next 15 years or 25 years? Economists say that equities should always beat bonds over the long haul, but not necessarily by the 7 percentage points of the last two decades. If the gap narrows to say 2 or 3 percentage points, or if tax rates change yet again, the advantage of sheltering stocks over bonds could disappear.
Investors with 10 or so years left until retirement might well take the conventional approach: bonds in the tax-deferred accounts, stocks outside. But those with longer horizons might try the newer strategy, placing part of their equity assets in sheltered accounts. Joel S. Dickson, an analyst at the Vanguard Group, thinks the new Roth IRA, in which you invest aftertax dollars, is the perfect vehicle for maximum gains: ''What comes out will never be taxed, so it pays to be aggressive and make the most money you can.''

EFFICIENCY COUNTS
Even the all-equity investor can take advantage of tax-deferred accounts to minimize taxes and maximize returns. The key: ''tax efficiency.'' The closer a fund's aftertax return is to its pretax return, the more tax-efficient it is.
How tax-efficient are your funds? You can find that data in the BUSINESS WEEK Mutual Fund Scoreboard that starts on page 90. (Aftertax returns are estimated, of course, since the exact numbers will vary from shareholder to shareholder.) Divide the pretax return by the aftertax return. The closer the ratio is to 1, the greater the tax efficiency. (This doesn't work if the fund's returns are negative).
Among the less efficient funds are large-cap value funds, which tend to own a lot of dividend-paying stocks; income-oriented portfolios such as real estate and utilities funds; hybrid funds that mix bonds with their stocks; or funds with hyperactive trading strategies, which tend to produce a lot of short-term gains--which are still taxable as ordinary income.
Index funds, because they don't trade their portfolios, are tax-efficient. But other than indexers, consider funds that invest in small- to midcap growth companies and pay little or no income distributions. Look at the Baron Asset Fund. Its 10-year average annual total return is 19.9% pretax and 19% after taxes--a 95.4% tax efficiency. But the kinds of companies in which these funds invest can be volatile.
Take on more volatility? If saving on taxes means that much to you, it might just be a worthwhile trade-off.

BEAUTIFUL LOSERS
Funds that have been pounded into the ground often have valuable tax losses. They're the result of having to sell securities at big losses in declining markets or to cash out fleeing shareholders. Most funds use losses to offset gains on the winners, but lately, emerging markets, Asian, and precious metals funds have had no gains to offset. The losses remain on the books (table, below).
If the fund rebounds, the manager can use those losses to offset future trading gains. So if you buy into a down-at-the-heels fund with large tax losses, you can effectively reap some tax-sheltered gains from the losses of earlier shareholders. In some cases, the losses are worth many times the current size of the fund. At Lexington Strategic Investments, a South African gold fund, losses are more than three times as large as the fund (table). American Heritage Fund, up 75% in 1997, still has enormous tax losses owing to years of red ink. Look for unused tax losses in the Mutual Fund Scoreboard as negative numbers under ''untaxed gains.''
Jumping into a loss-ridden fund is no guarantee of gains, especially when the sector is under water, as are gold or Asian funds. ''But if you find some positive changes at the fund, a new manager, a new philosophy, a new approach, it can be a good deal,'' says mutual-fund expert A. Michael Lipper of Lipper Analytical Services Inc. One candidate for such bottom-fishing: Fidelity Emerging Markets, one of the worst performers of 1997. Fidelity has since installed a new manager, and, says Lipper, ''from what I see so far, it looks promising.''
Lots of investors follow managers to their new funds, but that can have unpleasant tax consequences. Consider the Berger 100 Fund. A star early in the '90s, the fund has lagged recently. Last February, Berger hired Patrick Adams, formerly of Founders and Kemper, to rejuvenate the fund. Adams cleaned house. The 1997 returns were lackluster anyway--just 13.6%. But the wholesale trading of the portfolio resulted in a huge capital-gains distribution. Paying the taxes on the payout sliced the 1997 return to just 4.5%.
Adams' moves may yet pay off. But it's clear that they would pay off for taxable investors a lot sooner if there weren't such a large distribution. The moral: Taxes may play a larger role in what you earn than you might expect.
By Jeffrey M. Laderman in New York

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