Promising higher returns by lowering taxes

Some investors in mutual-fund shares are getting a shock these days. As they work out their federal and state taxes for the April 15 deadline, they find they owe Uncle Sam big bucks on the earnings of those shares.

Not all mutual-fund shareholders have that problem. About two-thirds of the 93 million mutual-fund shareholders in the US have money in tax-deferred accounts – such as Individual Retirement Accounts and 401(k) or 403(b) plans. They do not pay taxes on income or capital gains incurred by their investments until the money is withdrawn at retirement or otherwise.

But 69 percent of shareholders have some mutual-fund assets outside of qualified plans and are subject to taxes – in the billions, according to the Investment Company Institute.

Still, a minority of the latter group have invested in "tax-managed" funds that consciously strive to limit the tax bite with their investment strategy.

These funds "eliminate one of the biggest drags on mutual-fund performance: turning too much of their returns over to the United States government," says Duncan Richardson, portfolio manager of the $19 billion Eaton Vance Tax-Managed Growth Portfolio. They also "enable shareholders to regain control of their taxes," he says.

Since February, the Securities and Exchange Commission has required every mutual fund to include in its prospectus a table giving after-tax performance for 1-, 5-, and 10-year periods, as well as its pretax returns. That promises to give tax-managed funds a boost as investors see more clearly the size of Washington's tax take. It could "easily" take 1 or 2 percent a year off a mutual fund's performance, reckons John Shoven, an economist at Stanford University in Palo Alto, Calif. For long-term investors, that could compound up to 20 or 30 percent over 10 to 15 years.

While many fund investors know that management fees and sales fees shrink the return on their shares, fewer think about the largest cost of all – taxes.

Mutual funds must, by law, distribute at least 90 percent of their income and capital gains to shareholders. Even though shareholders may decide to have that money automatically reinvested in more shares, they still owe taxes on it.

With tax-managed funds, usually only a few percent or less of the return is subject to taxes.

The big question for investors: Do tax-managed funds have lower pretax returns than other similarly managed funds, so that the tax advantage is more than offset by a lower return?

That's not likely, says Professor Shoven. "Investors give up little if anything on before-tax performance and save on after-tax performance," he says.

Any fair comparison of the average performance of tax-managed funds with others would be tricky statistically. Experts know of no such study.

But Morningstar, a Chicago-based mutual-fund-tracking firm, recently published a list of tax-managed funds with after-tax returns that beat the average pretax return of the typical fund in their respective categories over the five-year period ended Feb. 28. Shareholders in these funds didn't sacrifice performance for the sake of tax sensitivity. "Most investors will get some benefit from using tax-managed funds," says Morningstar analyst Peter Di Teresa.

Page: 1 | 2