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Mutual fund success has taxing ramifications

Updated: May 3, 2013 12:14PM



Originally published: December 4, 2006

After a great year in the stock market, you might be delighted to see that your mutual fund shares are worth a lot more. But here’s something to wipe the smile off your face: A bill for taxes. Even if you don’t sell a share and reinvest all distributions, you could be paying a big tax bill -- unless your fund shares are in a tax-advantaged retirement account.

Mutual fund managers have been piling up huge gains on the stocks they purchased at lower prices in recent years. When a fund manager sells a stock at a gain, perhaps to reinvest in another company, the profits belong to fund shareholders. And so does the responsibility for paying taxes on those gains.

The gains are offset against losses, and then all net realized short- and long-term gains must be distributed to fund shareholders each year. As a result of the recent bull market, many funds now have far more profits than losses. Third biggest year ever

So this year should see a huge gains distribution, according to Duncan W. Richardson, chief equity investment officer, of the Eaton Vance family of funds. He predicts distributions could exceed $200 billion for 2006, making it the third largest year of distributions. In the bull market years of 1999 and 2000, the payouts reached $238 billion and $326 billion, but last year’s payout was only $129 billion, compared with $55 billion in 2004 and $14 billion in 2003 at the bottom of the bear market.

In December, mutual funds send shareholders a letter estimating the amount of taxable distributions, which include short-term capital gains, long-term capital gains and ordinary income from dividends. (Some funds also distribute “qualified dividend income,” which is taxed at the same rate as long-term capital gains.) Most fund companies also post these estimates on their Web sites in early December. The exact distribution numbers will arrive on your 1099 in January.

Each fund sets a critical date of record called the “ex-distribution” date -- the date you can purchase shares without receiving the gains distribution. The price of the fund shares is reduced on that date by the amount of the distribution. So while you don’t get the distributions, you don’t get socked with a tax bill either.

It’s unseemly to complain about gains in your mutual fund! They’re certainly better than losses. But there is something you can do to minimize those annual distributions, yet still invest in a fund that is performing well.

If you hold your shares outside a retirement plan, then consider a category called “tax efficient” funds.

They take a long-term investment view, and try to minimize unnecessary portfolio turnover. These fund managers are motivated to maximize “after-tax returns” by trading less frequently so fewer gains are generated inside the fund. And when they do have gains, they try to minimize them by taking losses on other positions. These “tax-managed” funds tend to have lower distributions. And a greater percentage of their distributions is likely to come in the form of long-term capital gains, which are taxed at a lower rate.

The Eaton Vance fund family has nine equity funds and a large group of municipal bond funds that are managed for tax efficiency. Eaton Vance’s Tax-Managed Equity Asset Allocation Fund, with more than $600 million in assets and a four-star Morningstar rating, has posted a pre-tax performance in the last year that ranks it in the top 10 percent of multicap funds in its group. In fact, it has outperformed its peer group and the S&P 500 and Russell 3000 indexes since its inception in 2002. Obviously tax management does not negatively affect performance.

Yet Richardson says this fund will distribute only 2.5 percent in gains this year, while many non tax-managed funds could have double-digit distributions. (For more information and a prospectus call 800-225-6265.) Retirement accounts are exempt

If you buy fund shares in a retirement account, this topic is moot. All your withdrawals will one day be taxed as ordinary income.

But for mutual funds held outside your tax-sheltered accounts, taxes do matter. There’s an old saying in the market: It’s not what you make, but what you keep that counts! And that’s The Savage Truth.

Terry Savage is a registered investment adviser and the author of The Savage Number: How Much Money Do You Need to Retire? (256 pages, Wiley, $24.95).



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