Watch the tax bite on mutual funds

By Roger Ibbotson

When Benjamin Franklin wrote, "In this world nothing can be said to be certain, except death and taxes," he sure made life sound simple.

He might not have been so pithy if he had lived to see just how uncertain today's ever-more-complicated tax system has become. Given fluctuations in the market and changing tax laws, there's nothing very certain about the amount of taxes individuals will pay each year on their investments, but there are some choices investors can make to significantly reduce their tax bills.

Just as fees vary from mutual fund to mutual fund, the taxes that different mutual funds generate also vary, sometimes dramatically, from fund to fund -- even within the same fund category. And the toll that taxes take on a taxable account can have a dramatic impact.

One of the most important rules in investing is to control the factors you can. The fees associated with purchasing investments are determined upfront, but the returns on investments are not. Investors can reduce market variability by diversifying their wealth across and within a number of asset classes. And investors can keep costs low by watching fees and employing a buy-and-hold strategy to lower taxes.

But just because the investor is buying and holding the mutual fund for the long term, that doesn't mean the portfolio manager is doing the same. The average turnover for stocks in an actively managed mutual fund is close to 100% in a given year. That turnover number includes share purchases as well as sales, and some sales are at a loss, but that figure still indicates a great deal of activity. Because fund managers are required to distribute the capital gains to investors each year, that turnover can result in some hefty taxes.

Emphasis has been on fees

Fees have been in the media a great deal recently and are explicitly stated for the investor. But taxes get less attention, both in the media and from investors, even though they can affect returns more significantly than fees. For example, the average fee on an actively managed mutual fund cuts approximately 1.4% from returns per year -- about 1% per year on an asset-weighted basis -- but taxes can cut an average annual return by more than a third.

Fund managers have little incentive to manage their portfolios tax-efficiently because that doesn't sell funds -- return performance sells funds. A large percentage of investors chase hot funds. And even the more pragmatic investors, who may look for consistent performance and low fee structure, rarely consider tax efficiency. The fact that few investors prize tax efficiency is evidenced by the fact that there are so few tax-managed funds -- they make up less than 1% of the mutual-fund universe. But what should really matter to investors at the end of the day is how much return they receive after all costs are paid, including taxes.

Management is the key

How a portfolio is managed can play a significant role in reducing taxes. Extremely efficient funds that have low turnover and offset gains with losses may make no disbursements from year to year, so the investor pays taxes only when selling the fund. Even portfolio managers who have some turnover can mitigate the amount investors pay in taxes. Equity investments that are held for at least one year qualify for the 15% capital-gains tax rate, as opposed to ordinary income-tax rates as high as 35%.

But with close to 100% portfolio turnover per year in the average fund, a significant percentage of gains are taxed at the higher ordinary tax rate, and that cuts a great deal from returns.

Let's take the example of an individual investor who puts $1,000 in a mutual fund that earns 8% per year over 10 years. If the investor had bought a tax-efficient fund or maybe a large-cap index fund, he might not pay any taxes for 10 years, at which point, after taxes, his investment would have grown to $1,985. If he had invested in a fund with moderately high turnover but it was managed to usually qualify for the 15% rate, it would have grown to $1,919 after taxes.

But if the fund was not managed efficiently and all gains were taxed at the 35% rate, that investment would have grown to only $1,599. The investor would have lost $560 to taxes at the ordinary tax rate instead of $240 at the capital-gains rate, and $174 if he deferred taxes until the sale of the fund. This works out to an average annual return of 7.1% if he deferred, 6.8% if he paid at the capital-gains rate and 5.2% at the ordinary income rate. Note that there is a difference of about 200 basis points from the highest taxes paid to the lowest, and these numbers don't include state taxes. This is a significantly wider spread than an investor would find, on average, if he price-shopped for mutual funds. And this money lost to taxes, compounded over a longer period -- say, throughout an investor's lifetime of saving -- multiplies because the tax-inefficient investor has a smaller principal invested each year in the stock market.

Take control of taxes

Investors should always look at pre- and post-tax-return performance before making an investment decision for their taxable accounts. Pre- and post-tax-return data is available on financial-research Web sites such as Morningstar.com.

Investors should also pay particular attention when investing in certain categories of funds. Small growth funds in particular tend to have high taxes associated with them simply by the nature of the category -- when small-capitalization companies grow too big, they must be sold to maintain the fund-style mandate. This is also true of certain index funds in which the index being tracked has high turnover.

In addition, certain times of the year are better than others for buying a mutual fund. Fund managers tend to make their annual distributions around November or December. So when the market has had an up year, investors may want to avoid making new purchases close to the year's end.

The real way to completely avoid capital-gains taxes is to die. When an individual passes away, the estate does not have to pay a capital-gains tax on the equity appreciation accrued while the investor was alive and holding the security. But since death and the markets are uncertain in the short term, it's important for an investor to manage the factors that are in his or her sphere of immediate control. Paying close attention to the taxes generated by an investment can significantly increase total return.