Updated: May 3, 2013 12:14PM
Originally published: June 17, 2002
Tax stories are out of season. But taxes continue, and that’s a very good reason to pay attention to the ongoing tax situation of your mutual funds.
If you own mutual funds inside a retirement plan--an IRA, Keogh or 401(k)--you never have to worry about capital gains taxes. When you withdraw your money at retirement, all of your gains will be calculated, and taxed as ordinary income.
But if your mutual fund investments are outside a tax-sheltered retirement plan, there are two major tax issues you must face every year.
The mutual fund tax bite
You incur taxes if you sell your shares in the fund. If you’ve held the shares for at least a year, you could be eligible for capital gains tax treatment: lower tax rates on your profits, and the ability to offset $3,000 of losses against ordinary income each year.
But the other mutual fund tax issue takes most people by surprise. It results from gains and losses inside the fund itself. The fund manager is buying and selling stocks inside the fund, and taking gains and losses on those transactions. Those trading gains and losses must be offset against each other. Then any gains taken during the year are passed on to shareholders to report on their own returns--even if they never sold their mutual fund shares. (Losses, however, are kept inside the portfolio, ultimately to be offset against gains within seven years.)
As many investors discovered to their shock two years ago, the net asset value of their funds’ shares actually declined, but the fund itself recorded gains on the sale of some stocks within the funds. Those gains were distributed to shareholders, resulting in a tax obligation for the year.
That’s why several major mutual fund companies have created “tax-managed” mutual funds that are run with attention to these potential gains distributions. They invest in the same stocks as other funds, but the managers seek to minimize those yearend distributions of gains. Of course, you could do the same with a simple index fund, which rarely sells stocks unless the index changes, but tax-managed funds aim to beat the benchmark indices.
Don Peters manages the portfolios of the T. Rowe Price Tax-Efficient Balanced Fund, Tax-Efficient Growth Fund, and Tax-Efficient Multi-Cap Growth Fund. While each fund sticks to its discipline, the funds also seek to maximize after-tax returns.
Says Peters, “We’re are investing for the long term, and plan to own the stocks we buy for several years.”
To be worthwhile, a tax-efficient fund must have both ingredients: good investment performance and low yearend distributions to shareholders.
Since the Tax-Efficient Growth Fund was launched in 1999, there have been no tax distributions. The fund broke even in 2000 and lost 15.5 percent in 2001, beating its benchmark Lipper large-cap growth index, which lost 23.9 percent.
Smart fund managers hoard their losses
The fund has a turnover rate of only about 15 percent per year. Like all investors, he has taken losses. But, says Peters, he’s hoarding those losses--which now total nearly 18 percent of the Growth Fund’s assets--to use in the future when he takes some expected big capital gains.
Tim Heffernan, who runs Fidelity’s Tax Managed Stock Fund, also is focused on after-tax returns, and has never had a capital distribution since the fund began in 1998. Performance is flat this year, and his fund lost only 12.4 percent in 2001, beating the benchmark index.
With both these portfolio managers, the question is will they ever get the future gains to offset the losses they’re allowed to carry forward for seven years? After all, it’s easy to take losses in a bear market.
Says Heffernan: “I feel confident that we’ll be able to make use of those losses in the next seven years. Now we can manage the portfolio even more aggressively to seek gains in cyclical stocks. And our investors will benefit from our after-tax returns.”
That’s what smart investors are seeking: after-tax returns. If you’re investing outside your retirement plan, it’s nice to know your portfolio manager is taking that into account. And that’s The Savage Truth.
Terry Savage is a registered investment adviser and is on the board of directors of McDonald’s Corp. and Pennzoil-Quaker State Co. Send questions via e-mail to firstname.lastname@example.org.