Funds that keep the IRS away
If you're shocked by the taxes you pay on your funds, consider these options.
March 5, 2002: 10:59 a.m. ET
By Staff Writer Annelena Lobb
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NEW YORK (CNN/Money) - It's tax time again. 1099 forms are piling up in your mailbox, reminding you that taxes on your investment earnings (not to mention your taxes on everything else) will soon come due.
Much like last year, mutual fund investors may have a particularly bitter pill to swallow. Whether or not their funds gained value in 2001, they'll likely get stuck paying capital gains and income taxes on distributions made during the year.
"Mutual fund taxes can cause a lot of grief," said Greg Brewer, manager of mutual funds research at Value Line, a New York-based independent investment research firm. "An investor may have an overall loss on the shares and still pay a capital gains bill -- it can feel a bit like an insult."
Indeed, taxable gains are the dirty little secret of the mutual fund industry. Until the bear market took hold two years ago, few investors gave after-tax returns a second thought, looking instead toward high-risk, high-reward investments that would make them millionaires overnight.
They're noticing now.
"I think investors have become more serious about the impact of taxes because they were saddled with tax bills in 2000 -- but many funds performed poorly as the market crashed," said Bill Harding, a tax-managed fund analyst at Morningstar.
A new breed
Tax-friendly mutual funds come in all shapes and sizes. Tax-managed funds are run with an eye to after-tax returns. Index funds don't trade much, keeping capital gains in check. And municipal bond funds also make the grade, with interest that is free from federal taxes, and sometimes state and local taxes.
"The average mutual fund has lost about 2.5 percent a year to taxes on dividends and capital gains," said Joel Dickson, a tax efficiency expert at the Vanguard Group. "Most funds are managed without regard to taxes, but taxes are something that can be controlled."
Over the long haul, minimizing your taxes produces a considerable payoff, according to the Vanguard Group. Say two investors place $10,000 in two funds that each pay pre-tax returns of 10 percent a year. But they have different after-tax returns -- one fund had an after-tax return of 9 percent a year; the other, just 7 percent.
After 30 years, the investment with the smaller tax bite grows to almost $133,000 after taxes -- about 75 percent more than the $76,123 produced by the more heavily taxed fund.
The average tax-managed domestic equity fund returned 2.87 percent over the past 3 years. Non tax-managed funds returned just 0.11 percent, according to Morningstar.
Tax-managed funds
If you've had it with Uncle Sam and you're ready to explore the brave new world of tax-managed funds, you'll need to understand how they work.
Stock dividends are taxed at ordinary income tax rates, which can climb as high as 38.6 percent. Short-term capital gains, which apply to gains realized in fewer than 12 months, are treated the same.
By contrast, long-term capital gains, for investments held for 1 year or more, are taxed at a maximum rate of 20 percent. Last year, that rate dropped to a maximum of 18 percent for securities purchased after Jan. 1, 2001 and held for more than five years.
Tax-managed funds emphasize after-tax performance by steering clear of dividend-paying stocks. They also limit their trading activity, or "turnover", to minimize the capital gains taxes you pay.
Tax-managed funds also employ a unique investing strategy, using losses during the year to offset as much of their gain as possible. The fund company can carry losses forward for up to 8 years.
"The bottom line is how much you have left over from your earnings, and in that regard, these funds have done a pretty good job," said Harding.
Tax-efficient funds work best in taxable accounts, rather than 401(k)s or IRAs. That's because retirement accounts already have tax advantages.
"In the context of an IRA or 401(k), there should be managers who do better than tax-efficient funds," said Don Peters, portfolio manager for T. Rowe Price Tax-Efficient Balanced Fund, T. Rowe Price Tax-Efficient Growth Fund, and T. Rowe Price Tax-Efficient Multi-Cap Growth Fund. "When it comes to taxable accounts, I think it's relatively rare to find a manager with a high turnover approach that does better than one with a tax-managed approach."
Popular tax-managed offerings include Vanguard Tax-Managed Capital Appreciation, which returned 8.61 percent over the past 5 years, after taxes on distributions, and Eaton Vance Tax-Managed Growth 1.0, which returned 10.65 percent over the past 5 years, after taxes on distributions.
"There are also many tax-efficient funds that aren't necessarily advertised as such," added Harding, who cited Third Avenue Value, Weitz Partners Value and Muhlenkamp among these somewhat-hidden gems.
Buying municipal bonds
If you're concerned about the effect of income tax and capital gains tax on the fixed-income portion of your portfolio, you may also want to consider municipal bond funds. "Munis" are issued by state and local governments and agencies.
Here's the good part -- interest earned on munis is exempt from federal taxes, and sometimes from state and local taxes as well, if you live in the state where the bond was issued.
Munis typically have a lower yield than do taxable bonds, but can often be a better deal for investors in higher tax brackets. To calculate whether municipal bond funds are right for you, compare your after-tax yield on a taxable bond fund with the yield on a muni fund. You can use CNN/Money's bond yield converter to find out.
The average yield on a 30-year municipal bond with a triple-A credit rating (the highest rating available) was 5.14 percent, at the end of December 2001, according to Bloomberg.
JP Morgan Tax-Free Income Select, for example, holds muni bonds from several different states, including Michigan, New York and Massachusetts. Vanguard's Tax-Managed Balanced fund keeps 50 percent of its holdings in munis. (The other half is kept in stocks that mimic the Russell 1000, with a bias toward low-dividend yielding stocks.)
Buying index funds
Index funds are another tax-friendly category.
Because these funds buy and hold whatever is contained in the index they track, they stay away from rapid-fire trading. That keeps their tax bills low.
"The main thing that will trigger taxes is high turnover," Brewer said. "If you're constantly buying and selling, you're constantly triggering taxable events."
Not all index funds are created equal, though, Dickson said. If shares of a certain company must be sold to keep a fund faithful to its corresponding index, there are more tax-efficient ways to do that.
"Say we have to sell shares of Cisco to match its standing in a particular index. We sell the shares we have with the highest cost basis," said Dickson. That yields a smaller capital gain, with less due in taxes on shareholders.
Dickson explained that these shares probably appreciated far more, and would generate heftier capital gains taxes.
Plus, large-cap index funds and total stock market index funds, like Vanguard Total Stock Market Index and Vanguard 500 Index, tend to be more tax efficient than small-cap index funds. "The small-cap index itself changes more," he explained. As a great fledgling company grows and increases in value, it begins to outgrow the small-cap index, becoming a mid-cap and eventually a large-cap company.
The company would eventually be sold if it were too big for a place in the Russell 2000, and earnings (therefore taxes) would likely be high if it skyrocketed through the index. But if shares of that same rapid grower were held in a total stock market fund, it would likely stay within the fund for a longer period of time. 
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