Taxing matters

How to shield your returns from Uncle Sam

If you’re a mutual fund investor, you don’t have to concern yourself with which stocks to buy or sell-the fund manager, of course, takes care of that for you. But one thing most fund managers don’t handle is your tax tab. In fact, many investors forget about this aspect of investing, but the IRS doesn’t. Taxes can clip nearly 2% annually from the average fund investor’s return.

“If you are working with an investment professional, that person should help you understand the tax consequences of your investment choices and especially subsequent actions that are taken,” says Marilyn Broussard, a certified financial planner and senior financial advisor with Waddell & Reed, a St. Paul, Minnesota-based financial services firm.

Mutual funds are required by law to distribute all of their realized capital gains and dividend income to shareholders each year. Dividend distributions must be reported as dividend income on your tax return.

Mutual funds also distribute long-term capital gains resulting from the profitable sale of stocks. These distributions are reported as long-term capital gains on your tax return regardless of how long you’ve owned the mutual fund. Most mutual funds allow shareholders to automatically reinvest distributions instead of receiving cash. But you must pay tax on reinvested amounts just as if you received them in cash.

That’s why when you buy shares of mutual funds, it can affect your tax liability. For example, if you purchase shares on December 1 and the fund distributes its 2000 capital gains and dividends on December 15, the payment is fully taxable even though you’ve only owned shares of the fund for 15 days. “If you plan to purchase shares in a mutual fund before year’s end,” says Dennis Filangeri, a Metaire, Louisiana-based certified financial planner, “pay close attention to the share price, because it may be higher than average immediately before the dividend distribution date.”

He adds: “That investors need to be aware of the expected date and amount of capital gains distributions, because the price of shares will drop to reflect that distribution. Keep in mind that you must use caution around the end of the year. Weigh the potential return of your fund selection against any potential tax consequences.”

In fact, some investors have leveled charges against the mutual fund industry claiming that it has ignored the tax consequences of such sales and treats all investors as if they are in such tax-deferred vehicles as IRAs or 401(k) plans. Some fund companies, however, are taking notice, and now offer tax-managed funds that are specifically designed to limit tax liability.

Tax-managed funds employ a number of techniques to achieve this objective. For instance, they keep portfolio turnover-the rate at which the fund manager buys and sells assets-low, because selling appreciated stock generates taxable gains. Also, these funds buy growth stocks that pay little or no dividends, since dividends are taxed as regular income. Among the funds with the best returns are Third Avenue Value (TAVSX) and the Standish Small Cap Tax-Sensitive (SDCEX). Of course, not all tax-managed funds are stellar

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