Mutual Fund Tax Bills Are Rising
Four ways you can cut your tax bill.
Fund Spy
April figures to be a cruel month for fund investors.
Fund investors' tax bills are on the rise for the fourth year running. The average capital gains distribution for U.S. equity funds in 2006 rose to 4.17% of assets compared with 3.32% in 2005 and 1.67% in 2004. For international equity, the average distribution was 4.98%, for balanced funds 1.95%, and for taxable bond funds 0.12%.
The cause of those payouts is of course a good thing. It means funds have produced solid returns for a few years running. Although returns were pretty good in 2003 and 2004, the distributions were small because capital gains were offset by realized losses during the early-2000s bear market. However, most of those losses are long gone.
A quick refresher on capital gains distributions: Mutual funds are required to distribute their capital gains once a year. They tally all the realized gains and subtract realized losses and loss carryforwards from the previous year to arrive at the total sum to be paid out. The distributions are made in equal proportions to all shareholders regardless of when they bought the fund. Then all the fundholders who own the fund in a taxable account have to pay taxes on those distributions even if they reinvest their distribution.
At this point there's not much you can do about those 2006 payouts because they've already happened, but you should consider strategies for dealing with future payments. Most funds still are sitting on sizable gains, so it's quite likely that payouts will continue to grow as funds sell their winners. Thus, barring a market correction, you can expect your fund tax bill to grow. That's a bad thing because you'll have more money at the end of the day if you can postpone paying capital gains as far into the future as possible. The reason is twofold. First, the time value of money means that money in today's dollars is worth more than in the future because inflation will have eroded its value. In addition, if you hold on to the money, it can compound over time in your fund, thus earning you more money.
Here, then, are a few things you can do to limit your tax bill.
1. Max out on tax-sheltered accounts. Taxable distributions are not a problem for 401(k)s, 403(b)s, and IRAs, so invest as much as the law will allow before you put money in your taxable accounts.
2. Consider tax-managed funds for your taxable accounts. Tax-managed funds such as those offered by Vanguard do a great job of avoiding making distributions because they realize losses on some holdings when they have to realize gains on others. After taxes are figured in, these funds generally put up superior returns.
3. Consider exchange-traded funds. ETFs don't have all the strategies available to tax-managed funds but they do have some unique features that help reduce their tax bill. Just make sure you've chosen one that is diversified, has low costs, and has low turnover.
4. Don't buy funds that have had huge returns over the past three years. Buy a fund with huge gains and you're going to get a huge tax bill regardless of whether you make any money yourself. So, tread carefully in hot areas. If you have your heart set on such a fund, at least put it in an IRA or 401(k).
Poll Results
A couple of weeks ago, I asked "Which popular fund has the best prospects?" This is how you voted:
22% - American Funds Growth Fund of America (AGTHX)
6% - Davis NY Venture (NYVTX)
47% - Dodge & Cox International Stock (DODFX)