Markets & Finance

Tax-Savvy Moves for Fundholders


The mid-March tip-off of college hoops' annual Madness means more than just great TV. It also means "brackets" -- fans' yearly chance to fill in a labyrinthine betting sheet to track how they think the 64 teams in the tournament will fare. While the word bracket conjures the excitement of college basketball, it also has another, more unpleasant, association at this time of year: the countdown to Apr. 15.

Mutual-fund investors, in particular, may have additional reason to dread this tax season. Fund shareholders' total bill -- covering dividend income and capital gains -- to Uncle Sam jumped from $9.6 billion in the 2004 tax year to an estimated $15.2 billion in 2005, according to a soon-to-be-released report by fund tracker Lipper.

MORE CAPITAL GAINS. Investors who have read their 1099-DIV forms can probably see why. A fund realizes a capital gain when it sells a security for more than its purchase price. If the fund's capital gains outweigh its capital losses in a given accounting year, it must pass the difference along to shareholders. Funds must also pass along any income their securities generate, such as a bond's yield or a stock dividend.

These distributions are taxable, unless the fund is held in a tax-favored account like a 401(k) or IRA. In recent years, bear-market losses helped many funds offset their capital gains, saving shareholders on tax day. The clock ran out on that strategy in 2005, analysts say, meaning more capital gains -- and bigger checks to the taxman.

But fear not. As with college basketball's big dance, there's always next year. This Five for the Money presents BusinessWeek Online's own March bracket of attractive, tax-savvy mutual funds to help investors lighten their load.

1. Consider a tax-managed fund.

Sounds obvious, right? Investors trying to trim their tax liabilities should pick funds that seek to do the same. Still, many people assume that avoiding agony at tax time means sacrificing returns.

Not necessarily, recent research finds. Both before and after taxes, tax-managed funds beat their conventional peers in at least half of the 10 years ended in 2004, according to a study last year by Lipper. "Some of these funds are pretty good," says Tom Roseen, a senior research analyst with Lipper.

The Vanguard Group's tax-managed lineup is a good place to start. The Vanguard Tax-Managed Appreciation Fund (VMCAX) has a low 0.14% expense ratio and benchmark-beating returns on a three-, five-, and 10-year basis. "None of Vanguard's tax-managed funds have distributed a capital gain in their history," says Sonya Morris, a fund analyst with investment researcher Morningstar (MORN).

Eaton Vance Tax Managed Value (EATVX) has put up impressive numbers of its own. With a 1.21% expense ratio, the fund has three-year and five-year returns that outpace its peers and the S&P 500 index alike. Portfolio manager Michael Mach's turnover rate in some years tops 100%, counterintuitive for a tax-managed fund. "Low turnover has typically been considered a characteristic of tax-efficient funds, but there are exceptions," says Katherine Gallagher, a Standard & Poor's fund analyst.

2. Mind your munis.

For fixed-income investors, municipal-bond funds can be a tax-savvy choice. Unlike their taxable counterparts, municipal-bond funds provide yield that's usually exempt from federal income taxes. This income may also be free from state and local taxes, if the investor lives in the state where the bonds were issued.

Municipal-bond funds don't only keep the IRS at bay (see BW Online, 12/26/05, "Income Investing: Don't Come Up Empty-Handed"). Lately, they've also been posting better performance than their taxable brethren. Last year municipal-bond funds posted before-tax returns of 2.63%, compared to 2.06% for taxable fixed-income funds, according to Lipper. "Take in the tax consequence, and all of a sudden muni-bond funds yield quite a bit more," Roseen says.

Again, Vanguard offers a range of low-cost municipal-bond funds, such as Vanguard Intermediate Term Tax-Exempt (VWITX) and Vanguard High-Yield Tax-Exempt (VWAHX). Morningstar's Morris also recommends Fidelity Intermediate Municipal Income (FLTMX) and USAA Tax-Exempt Intermediate-Term (USATX).

Still, not all municipal-bond funds dodge the alternative minimum tax, which affects a growing number of taxpayers (see BW Online, 1/12/06, "Coping With the Alternative Minimum Tax"). Investors concerned about the AMT should consider funds specifically tailored to avoid it, like Fidelity AMT Tax-Free Money (FIMXX) or American Century Tax-Free Bond (TWTIX).

3. Win for losing.

Funds with large capital losses to carry forward are less likely to pass on taxable gains. So investors can trim their tax bills by picking funds in out-of-favor categories. Many large-cap growth funds, for example, have built up tax losses (see BW Online, 1/26/06, "Sluggers Among Large-Cap Growth").

One large-cap growth fund with solid performance and plenty of capital losses is Harbor Capital Appreciation (HCAIX). The fund has posted three-year returns of 19%, slightly ahead of the S&P 500, and has a -3.7% potential capital-gains exposure, according to Morningstar.

Vanguard Growth Equity (VGEQX) has had similar performance, and boasts a whopping -55.4% potential capital-gains exposure. But the fund "can be extremely volatile," says Morris.

4. Look for managers with skin in the game.

Having a large stake in a fund gives portfolio managers added reason to be tax-efficient. After all, they have to bear the consequences of any unnecessary capital gains. Thanks to disclosure requirements adopted in 2004, investors can now see to what extent their fund managers are sharing in the fund's after-tax returns.

All the lead managers have significant ownership stakes in Vanguard Primecap Core (VPCCX), the only Vanguard fund run by the typically tax-savvy Primecap that's still open to new investors. Fairholme (FAIRX) and Third Avenue Value (TAVFX) are two other tax-efficient funds where the managers have substantial holdings, says Morris.

Investors might also want to look at Vanguard Windsor II (VWNFX), where manager Jim Barrow of Barrow Hanley has a hefty ownership stake. In addition, Bridgeway Capital Management founder John Montgomery has big holdings in the 10 Bridgeway funds he manages.

5. Track an index.

Index funds are inherently more tax-efficient than the typical actively managed fund. Low turnover rates mean portfolios like the Vanguard 500 Index Fund (VFINX) or Fidelity Spartan 500 Index Fund (FSMKX) have relatively light potential capital-gains tax exposure. Their returns, especially after taxes and expenses, are usually competitive.

Exchange-traded funds are another index-based option for tax-savvy investors. ETFs like SPRD (SPY) or the iShares S&P 500 Index Fund (IVV) tend not to pass through capital gains. There are a few exceptions, though, such as StreetTracks Dow Jones Wilshire Small Cap Value (DSV).

There can be only one winner in the NCAA tournament. But with this wide range of options, any mutual-fund investor should be able to make next tax season a slam dunk.


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