NEW YORK (CNNfn) - The unfortunate side of successful fund investing is higher capital gains taxes, but tax-managed funds try to minimize the bite you'll take in April.
However, tax-managed doesn't mean tax free and the cautious investor should know the facts before thinking they've found a way around Internal Revenue Service capital gains taxes.
Basically, mutual funds distribute money to shareholders in two ways; through income distributions and capital gains distributions.
Income distributions are all the interest and dividend income earned after you take out the fund's expenses.
Capital gains distributions are what the fund makes when it sells a security at a profit. A security sold for less than it cost is a capital loss.
Tax concerns are usually secondary for many fund managers, who are eager to boost the overall return, an important number used by investors to gauge fund performance.
Capital gains garner strong interest from the IRS, which taxes them at a rate of up to 39 percent for the most wealthy investors. State and local governments may also take a cut. Altogether, Morningstar analysis showed that in 1997 the IRS skimmed off $150 billion in capital gains taxes.
For these reasons, investors are always on the lookout for a way to keep some of that money out of the government's coffers and the mutual fund industry in recent years has stepped forward with what they hope will appease these tax-weary investors.
The funds go by various names, using phrases such as "tax-managed" or "tax-efficient" and try to use strategies that reduce the current capital gains taxes you pay.
A fund that buys and sells stocks rapidly (and hopefully at a profit) tends to generate a lot of capital gains taxes.
The rate at which fund managers buy and sell stocks -- known as the turnover rate -- can be high, generating lots of capital gains and taxes. A fund with a 75 percent turnover rate sells 3/4 of its stocks over the course of a year. In addition to capital gains, this also generates other transaction fees which are hoisted onto the shareholders.
To combat this, tax-managed mutual funds often employ the old "buy and hold" strategy, lowering the number of transactions until a later date.
Laura Lallos, senior analyst at Morningstar, Inc., managers also use a different approach when they do sell those shares.
Under most circumstances, a fund manager will sell the earliest-bought shares of a stock first, since they probably had the lowest purchase price and will bring the greatest profit. This is generally known on Wall Street as "first in, first out."
However, Lallos said managers of tax-managed funds do something more like "last in, first out."
"They're often careful to trade shares they purchased more recently, which will tend to sell for less capital gains," said Lallos.
Objectives and achievements
Tom Belisari, a certified financial planner at Key Financial in Philadelphia, understands the attraction of lower taxes, but is skeptical about such funds.
"The tax-managed fund is the objective," he said. "Whether or not they can achieve it is completely different."
Tax-managed funds can also give investors a false impression if they're not careful, said Belisari, who noted "tax-managed" can often get translated as "tax-free" in the mind of a potential investor.
Indeed, even with a tax-managed fund you will still have to pay the government. "At some point, you're going to need this money and when you do, you're going to pay taxes," he explained.
A best case scenario, he said, would be having your money in a tax-managed fund and withdrawing it when you retire, a time at which your tax bracket - and therefore your capital gains taxes - would presumably be lower.
Focusing too much on taxes can hurt your overall investment plan anyway, according to Jim Bell, president of Bell Investment Advisors Inc. in San Francisco.
"We sometimes have clients who are obsessed with taxes and we try to point out to them the bigger picture," said Bell. "Most people want to have their net worth grow. If they have to pay more taxes, so be it."
Bell tries to steer his clients toward the best-performing funds to that end, spotting trends and focusing on recent performance.
It's not as if Bell ignores tax issues. When comparing two or more funds which are performing acceptably Bell will then use the more tax-efficient fund. He doesn't, however, start with a fund's tax efficiency when evaluating it.
You might not even need to buy a "tax-managed" fund in order to get tax-efficiency anyway. Many funds inadvertently generate low capital gains.
For example, index funds, which attempt to mirror the overall performance of a certain market benchmark, tend to have lower turnover and thus, less capital gains. Bell singled out Vanguard Growth Index Fund (VIGRX) as a solid performer with a taxable distribution of just 1 percent in 1998.
-- by staff writer Randall J. Schultz