Maximizing Tax-Cut Savings with Mutual Funds

As the fund industry sifts through the details of the recently passed dividend-tax cut, some interesting nuggets have been unearthed, and Vanguard tax guru Joel Dickson says he's found some advantages that are unique to the fund format. He spoke on the topic Friday at the 2003 Morningstar Investment Conference in Chicago.

For example, the new law stipulates that a fund that earns 95% of its income from sources that are covered by the new lower dividend-tax rate can actually treat 100% of its income as tax-advantaged. So, if a fund gets 95% of its income from stock dividends, but the remaining 5% comes from bonds, Treasury bills, or REITs, the fund can roll up all its income in the form of a distribution that will be taxed at the lower rate. If you owned a similar mix directly or through other vehicles such as separate accounts, you wouldn't get that advantage.

In addition, funds take their expense fees out of their income stream, and they are allowed to designate income taxed at higher rates to pay for the expense ratio. So, if a fund generates only 90% of its income from tax-advantaged equity dividends, but its expense ratio sucked up 10% of its income stream, the fund could still pay out all of its income in a lower-tax-rate payment, because the income that would have been taxed at the higher rate went into paying expenses. Again, you wouldn't get that advantage if you were paying a separate account or wrap fee on your holdings.

Allocation Funds Get More Attractive
The story gets really interesting when you look at balanced funds, Dickson explained, because, again, the fund can allocate all the income taxed at the higher rate for the expense ratio. 

Consider a fund whose underlying portfolio yields 2.50%, with 2% coming from higher-tax bonds and 0.50% coming from lower-tax stock dividends, and which charges a 1% expense ratio. The fund could then throw off 0.50% of yield at the lower rate and 1% at the higher rate. As a result, you'd get more income taxable at the lower rate than you would if you had bought a stock fund and bond fund separately. Had you bought them individually, you'd have lost lower-tax income in the stock fund by paying for an expense ratio.

Other Implications
Dickson has also given some thought to the best way of allocating different funds to taxable and tax-sheltered accounts. For the most part, you want to keep your taxable bonds in tax-sheltered accounts, Dickson says. However, if you're in the top tax bracket, then munis are a better deal than taxable bonds. Thus, you'd want to put munis in taxable accounts and put nearly all your tax-sheltered account money into stock funds.

Another decision to make is where to put dividend stocks (or funds that buy them) and growth stocks, which pay low or no dividends. Dickson says that even though they are taxed at the same rate as dividends, capital gains are still a slightly better deal because you can postpone paying gains into the future while your returns compound. In addition, you can reduce your tax bill when you realize a capital loss. Thus, you might want to have a little more growth in your taxable accounts and a little more value in your tax-sheltered accounts.

A Missed Opportunity
Unrelated to the latest tax bill, Dickson called attention to an alarming study finding that 19 million households held their investments only in taxable accounts. Some of those investors are in that position because of having to wind down their tax-sheltered accounts in retirement. However, many are folks who are just plain missing out.

The first places to go with long-term investments are tax-sheltered accounts such as Roth IRAs, traditional IRAs, and 401(k)s. If you aren't doing that, you're passing on free money.