Hidden Taxes on Mutual Funds

by Steven Sodini 5. February 2013 16:28
Thanks to the recently enacted American Taxpayer Relief Act of 2012, tax rates are going up for the highest income taxpayers. Even those slightly lower on the earnings ladder are getting hit with new taxes from the 2010 Affordable Care Act (aka “Obamacare”), and all of these tax increases are arriving just as many mutual funds are poised to pay out larger taxable gains. A recent insightful article in the Wall Street Journal offers some suggestions on how to limit and reduce the tax impact from fund returns. To begin with, investors may want to think twice about strategies marketed recently for unstable markets. Some strategies that may be good in dealing with the ups and downs of the market, might also may produce more tax liabilities than investors are willing to endure.  The primary reason is that the more actively a fund is managed, the more potential it has to produce short-term gains and thus higher taxes. Gains from securities owned for a year or less are taxed as ordinary income, and under the new tax laws noted above, these rates that for most investors are now much higher than the new maximum 20% on long-term gains. The easiest way to see the tax impact of a fund's return, is to go to Morningstar.com and search for a certain fund, then just click on the tax tab. There you'll see the fund's tax-adjusted returns broken down for various periods of time.  In addition, Morningstar also shows how funds rank with their peers, in terms of how much of their returns are lost to taxes.  A fund that generates a lot of interest (such as a taxable bond fund) or short-term capital gains (such as funds with active trading goals) should go into a tax-deferred retirement account, like an IRA or 401(K).  Distributions from retirement accounts are taxed as ordinary income, and most investors are normally in a lower tax bracket when they retire. But regardless of what bracket you retire in, many advisers often recommend deferring paying tax on interest and capital gains for as long as possible. Meanwhile, your taxable account should be used for stock funds whose trades mostly qualify for the long-term gains rate, along with tax-exempt municipal-bond funds and equity funds that focus on dividends that qualify for the maximum 20% rate.  A fund's prospectus usually will state whether its portfolio is managed with an eye toward holding down taxable distributions. Also look for the "turnover rate," or the percentage of a fund's holdings that change in a 12-month period. Many funds have turnover of around 100%, so for a fund to be in a taxable account, the turnover rate should be about 25% or less.  When a fund sells more securities at a loss than a gain, the excess losses can then be applied to reducing or eliminating taxes in future years.  Before 2010, funds could carry losses forward for up to eight years, but following a change in tax law, losses incurred in fund tax years that begin after Dec. 22, 2010, can now be carried forward indefinitely.  Since the 2008 market downturn, many funds have been able to keep distributions low by using losses to offset gains.  However, many funds have now used up all their loss carry-forwards, so when they sell profitable positions now, they likely will have to pay out taxable gains. However, be very cautious with funds that had outstanding performance over the past three years.  If a fund has had a good run the past few years and is near the end of a successful run, a lot of investors could bail out, forcing the fund manager to realize gains in order to meet redemptions.  Therefore, such a fund may have to pay out substantial gains, even though its net asset value is declining.  A fund's annual report should say whether it is carrying unrealized gains or losses, which can also be found by clicking the tax tab on the fund's page at Morningstar.com, which shows how much of a fund's portfolio represents unrealized gains or losses.  If there is a larger unrealized gain or 30% or more and the fund has high turnover, then it’s likely to distribute gains in the next few years. Many advisers also caution against letting taxes alone drive investment decisions. But there can be advantages to generating losses when the chance arises, especially if you plan to raise cash later in the year by selling securities at a profit. During a time of sudden market shifts, losses may not stay losses indefinitely.  Under current tax law, you can also avoid taking a big gain in appreciated fund shares by donating the shares to a charity, which is a good way to be both charitable and reduce your tax bill.  By giving the shares to the charity, you can deduct the full value, and avoid paying capital-gains tax on the appreciation at the same time.  Furthermore, once the donation is completed, you could actually buy new shares of the same fund at the current, higher price, establishing a higher cost basis and reducing the tax bill on any future sale.  Furthermore, many firms offer tax-managed equity funds that aim to minimize taxable distributions. When such funds sell part of a position in a stock, they pick shares that will trigger the lowest tax bill, and they try to match up gains with losses taken elsewhere in the portfolio.  Passive funds that are based on broad market indexes can be among the best at avoiding taxable gains distributions. Their portfolios change only infrequently, and primarily because of component changes in the indexes they track. Tax-cost ratio is the percentage of a fund's annualized return that is reduced by taxes paid by shareholders on its distributions. The average tax-cost ratio for all funds followed by Morningstar is around 1%, which is another way of saying that an average one percentage point of fund return is lost to taxes each year.  Some passive funds, like small-cap index funds, change more often. As small-cap companies mature, they graduate to other categories and need to be replaced in an index. Tax implications should be of less concern than whether a fund meets your investment objectives. But the funds that you own should be tailored to your specific tax situation.  A taxpayer in one of the two lower federal tax brackets may actually do better by owning a taxable bond fund than a tax-exempt municipal-bond fund. An investor in a long-term municipal-bond fund would get less than 3% interest. Even after paying tax at 15%, an investor might get nearly 4% from a taxable high-yield bond fund.  At the end of the day, it's after-tax total return that will matter to most prudent investors.
Categories: Tax