Mutual fund tax bite at record $24 billion
New report shows distributions from capital gains, dividends and other income led to big tax bill in 2006.
NEW YORK (Money) -- Mutual fund investors got slammed by Uncle Sam in 2006.
A report by Lipper, a fund research company, found that shareholders in taxable fund accounts paid at least $23.8 billion in taxes. That figure reflects the impact on investors who simply held their funds and reinvested their distributions - those who sold fund shares during the year would have paid even higher taxes.
Overall mutual funds distributed a record $418.5 billion in 2006, including short-term and long-term capital gains, as well as dividend and interest income. That surpasses the fund distribution record previously set in 2000 of $376.6 billion.
One key reason that mutual funds also paid out such hefty taxable distributions is because they can no longer carry forward the steep losses incurred during the 2000-2002 bear market, which had been used to offset gains in recent years.
Says senior analyst Tom Roseen of Lipper, "The tax holiday is over."
Another incentive for the payouts is the 2001 tax law, which reduced the tax on qualified distributions to 15 percent from as much as 35 percent. As investors have demanded steady yields, stock fund dividend distributions soared 222 percent from 2002 levels.
The four year bull run in the stock market also led to big taxable gains, as funds sold more winning stocks. For example, one of the top performing fund categories, world equity, returned an average 25.7 percent last year. But Lipper found that once taxable distributions are accounted for, the average world equity fund returned just 21.8 percent to shareholders, or 15 percent less.
Over the past 20 years, the average investor in a taxable stock fund gave up the equivalent of 17 percent to 44 percent of their returns to taxes, Lipper found. In 2006, the tax bite amounted to a hefty 1.3 percent of assets, which is surpasses the average stock fund expense ratio of 1.2 percent.
That tax bite is likely to cost shareholders for the 2007 tax year, even as many forecasters say returns may slow down. "With the tax loss carry forwards disappearing, the tax bite on returns is likely to shoot back up to rates of 2 percent or more," says Roseen. "And now that we are in an aging bull market, this year may give us mediocre returns plus a huge tax bill, which should be of concern to investors."
To minimize future tax hits, Lipper recommends that investors hold tax-efficient funds in their taxable accounts, such as index-funds or tax-managed funds. These funds typically buy and hold the stocks, which helps reduce taxable distributions, or use losses to offset gains.