Tax-Smart Guide to Choosing Mutual Funds

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Tax-Smart Guide to Choosing Mutual Funds
Sue Stevens
Morningstar, Inc.
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ith mutual funds, what you see isn't what you get in many cases.

Reason: Taxes. Funds report their performance pretax. For investors, the after-tax results can be much different.
Example: In a recent 10-year period, American Century Equity Income Fund (TWEIX) had an annualized return of 12.85%. That return placed it among the top 2% of all funds in its large-company, value-stock fund category.
DWS Dreman High Return Equity (KDHAX) fund, another in the same category, was a cut below, with a 10-year annualized return of 12.06%. Over those 10 years, the difference in return before taxes would have been more than $2,200 for every $10,000 invested.
But after tax, according to Morningstar Inc., the DWS Dreman fund was ahead in "tax-adjusted" terms (see below), with gains of 9.99% a year, versus 9.16% for the American Century fund. Over those 10 years, the DWS Dreman investor would have been ahead by about $1,900 for each $10,000 invested, instead of lagging by $2,200.
MAKING A DIFFERENCE
Such differences are by no means unusual. Some mutual funds are more tax efficient than others. Over an extended period, this can make a big after-tax difference to investors.
Crunching the numbers: To arrive at these tax-adjusted returns, Morningstar follows procedures outlined by the federal Securities and Exchange Commission (SEC)...
-All distributions of income are assumed to be taxed at the highest federal rate that year (now 35%).
-Distributions of short-term gains are taxed in the same manner.
-Distributions of long-term gains are assumed to be taxed at the maximum rate for such gains that year (now 15%).
It's true that relatively few taxpayers are in the top federal tax bracket, which doesn't kick in until $336,550 of taxable income this year (on single or joint returns). On the other hand, the SEC formula does not include state or local income tax, which many investors must pay. Ultimately, these hypothetical tax-adjusted returns deliver a reasonable approximation of how investors actually fared and are valuable for comparisons.
LOSING FROM GAINS
Among stock funds, income from dividends now averages only around 0.3%, so they are not the main cause of tax inefficiency. Instead, capital gains distributions play a key role.
How: Stock funds generally trade their portfolios frequently during the year. Most trades result in a gain or loss for the fund. Each year, the fund must tabulate its net gain or loss for the year. The law requires a mutual fund to distribute capital gains to shareholders if the fund sells securities for a profit that can't be offset by a loss.
Example: ABC Mutual Fund has 10 million shares outstanding. This year, its trading activities generate a $25 million net gain. Thus, investors will receive a $2.50-per-share capital gains distribution. If Janice Jefferson holds 1,000 shares of ABC, her distribution will be $2,500. If some of those gains were from stocks held for a year or less, part of the distribution will be reported as a short-term gain, taxed to shareholders at rates up to 35%. Otherwise, the gain will qualify for favorable long-term capital gains rates, now generally 15%.
Trap: Tax will be owed on those gains, even if the distribution is reinvested in the same fund or in another security. Thus, investors may have to pay tax on "distributions" even though they haven't received any cash. What if a fund has net losses from its trading? Such losses are not passed through to shareholders. However, net losses are "banked" by the fund so they can be used to offset any future trading gains and thus spare investors some tax pain.
TRADE SECRETS
Mutual fund tax inefficiency is caused largely by each fund's trading patterns. Funds that trade heavily are most likely to incur capital gains that are passed through to investors. A fund that turns its portfolio over rapidly may generate expensive short-term gains. What's more, buying into a fund at the wrong time can lead to high taxes, as investors learned in the 2000-2002 bear market.
What happened: The technology, media, and telecommunications stocks that led the 1990s' bull market fell sharply. Funds holding those stocks sold them off to prevent further losses and also to raise cash needed to pay investors who were redeeming shares. In many cases, those stocks were bought years earlier, at substantially lower prices, so the funds had huge capital gains on these sales.
Trap: Those gains were passed through to all investors, newcomers as well as those who had been in the funds for years. Investors who put money into a growth fund in 2000 might have received hefty tax bills, that year and in those that followed, even while suffering sharp losses as the fund's share price fell.
DOWNSIZING DISTRIBUTIONS
To reduce your risk of such lose-lose investing...
-Evaluate a fund's history.
A fund that has consistently distributed sizable gains to investors in most years may have a management philosophy of heavy trading. Such a fund is likely to continue to distribute taxable gains.
Before you invest, ask your broker or a fund sales representative about its distribution record.
On-line, you can go to www.morningstar.com and enter a fund's ticker sym*bol in the "Quotes" search box. Then click on "Tax Analysis" to find the fund's tax-adjusted return and tax cost ratio. (There is no charge for this.)
Data also are available in Morning*star Mutual Funds, a binder of periodic fund profiles. Cost: $549/yr. for 24 issues. But you may also find this at your local library.
Generally, if a stock fund has a tax-cost ratio (which shows how much of its return would have been lost to tax each year) of more than 1.25, it should be held in a tax-deferred retirement account. Bond funds with tax-cost ratios of more than 2.0 also work best in a tax-deferred account. -Be wary of built-in gains. Funds having a portfolio filled with highly appreciated stocks may have a potential capital gains exposure of 40% or more of assets. If those shares are sold, the gains could produce big tax bills for investors. Conversely, funds with loss carry forwards might be worth considering partly for that reason.
Example: Alger Large-Cap Growth Fund (ALGAX) recently had a potential capital gains exposure of -36%, indicating the size of its loss carry forward.
Caution: A loss carry forward should not be the primary reason to buy a fund. A fund's past performance, management expertise, and so on, are more important. Again, information on potential gains and loss carry forwards is available from your broker, the fund company, and from Morningstar.
-Consider tax-managed funds. Some funds explicitly manage their portfolios to minimize investors' tax bills. They trade little and take losses to offset any trading gains. Such funds generally have "tax-managed" in their name. Vanguard Tax-Managed Growth and Income Fund (VTGIX), for example, gets four stars (out of a possible five) from Morningstar. -Consider index funds. Funds designed to track a particular index usually hold the stocks in that index. They tend to trade infrequently and thus don't incur much in the way of taxable capital gains.
So-called exchange-traded funds (ETFs) are index funds that trade like stocks. They're generally tax efficient.
Bottom line: If you hold mutual funds in a tax-deferred account, such as a 401(k) or an IRA, tax efficiency won't matter. You won't owe any tax until you withdraw money. In a taxable account, taxes count. It's wise to evaluate a fund primarily on its management, philosophy, track record, and other fundamentals -- but take a hard look at its tax efficiency before you invest.
 
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