Mutual Fund Tax Bills Rise Sharply: How You Can Avoid Them

No doubt about it, mutual funds are getting more taxing.

Taxable capital gains distributions doubled in 2005 versus 2004. The average diversified U.S. equity fund distributed 3.32% of its assets as capital gains last year compared with 1.67% in 2004. The story is much the same if you consider foreign and sector funds: The average distribution was 2.93% versus 1.46%. For both groups, those 2004 figures were also up sharply from 2003 when the average distribution was less than half a percent.

The number of funds making capital gains distributions also rose. Among diversified U.S. equity funds, the figure went from 64% to 74%. Among all stock funds it surged from 69% to 79%.

The reason capital gains spiked is that 2005 was the third positive year in a row for most equity markets. Moreover, small caps have been on a five-year tear and therefore now hold very few positions at sizable losses. In addition, the bear market is now fading into the distance as the market climbs higher.

The upshot is that you had better start paying attention to tax issues on your mutual fund investments if you haven't before. The market, particularly small caps, has already enjoyed solid gains so far in 2006. Even if the market finishes the year flat, however, you'd be wise to build a tax strategy.

Tacks to Try
Mutual funds have to distribute all the capital gains they realize (after subtracting capital losses and tax-loss carryforwards). However, those that use a tax-aware strategy to reduce distributions have proved quite successful at minimizing capitals gains distributions.

That, in turn, means you can significantly increase your aftertax returns by buying tax-managed funds or, at a minimum, low-turnover funds for your taxable accounts and avoiding super tax-inefficient funds.

By buying funds that hold on to their gains rather than distributing them, you enjoy two big advantages. First, you get to keep your money compounding in those mutual funds rather than pay it out in tax. If you can hold on to another $5,000 a year through savvy tax management, that can end up as a princely sum in 20 years. Second, by deferring taxes into the future, you're making the most of the time value of money. Because of inflation and the fact that you can compound money over time as compensation, a dollar today is worth more than a dollar in 10 or 20 years. Thus, if you put off a tax bill well into the future, you're effectively giving yourself a tax cut.

Consider this: 81 funds returned between 10% and 10.5% annualized on a pretax basis for the trailing 10 years ended Jan. 31, 2006. Yet within that group aftertax returns ranged between 2.64% and 10.17%. (Those figures are what you'd have if you held on through the whole period. If you sold at the end of the 10 years, you would also be subject to taxes on your gain. On this postliquidation basis, the gap from top to bottom narrows a bit but it's still enormous. It's 4.63% at the bottom and 9.15% at the top. The midpoint was 7.95%.)

One reason for the disparities in both cases is that many funds pay no attention to taxes and therefore are effectively leaving money on the table that would have benefited shareholders in taxable accounts. Yet, tax-managed funds have proved remarkably able to reduce gains distributions without sacrificing pretax returns. Some of the top tax-managed funds include  Third Avenue Value (TAVFX),  Vanguard Tax-Managed Balanced (VTMFX), and  Oakmark Fund (OAKMX).

As you build out your taxable holdings, be sure to look for good tax-managed alternatives. Exchange-traded funds and plain old index funds are also good bets. ETFs have some special features that enable them to avoid capital gains distributions, but even regular index funds do a good job of it because they have low turnover and can book losses by keeping close track of the cost basis of all their holdings.

One other thing you can do is write your congressional representative and tell them to eliminate the unfair treatment of mutual funds. Investors don't pay capital gains on stocks until they sell the stock, but fund investors have to pay taxes along the way because funds have to distribute their gains even to fund investors who may not have earned a profit. Last week at a conference run by the Mutual Fund Directors Forum, Rep. Richard Baker (La.) was asked if he would pick up this cause again, and he said Congress wasn't interested in it at the moment, but if enough people wrote their congressional representative, Congress would be motivated to pass the bill. So, here's your chance.

Make no mistake, the bear market meant you could avoid worrying about cap gains distributions for a while, but today you do so at your own peril.

Investors Worry About Asset Bloat
In my last Fund Spy, I asked "Do you own a fund that's getting too big?" Here's how you voted:

87% - Yes

13% - No