How to keep tax bite from eating up fund profits

The hefty profits rung up by stock funds in 2006 have made many mutual fund investors smile. Delightful as that may appear, there's a darker side as well – a sizable tax bite on April 15.

Capital-gains distributions promise to be at their highest levels since 2000. While distributions have risen every year since 2002, fund loss carry-forwards have mitigated the tax impact to shareholders. That's about to change, says Tom Roseen, senior research analyst at Lipper Inc. Bulging tax liabilities will be a wake-up call for many investors who tend to ignore the eroding impact of taxes on stock fund returns, he says.

"Most investors pay much more attention to a fund's total returns as reported in financial media than they do to after-tax results, which are what really matter," he says.

Mutual funds must distribute to shareholders all capital gains they realize, after subtracting capital losses and any tax-loss carry-forwards. As a result, taxes represent the largest drain on long-term fund performance, greater than operating expenses and sales loads combined. For the 10-year period through 2005, taxes chipped almost 17 percent off the gross return of the average US diversified equity fund, according to Lipper. Unless owners hold their fund in an IRA or other tax-deferred account, taxable stock funds lose from 1.5 to 2.5 percentage points of return each year from federal income taxes. For owners of bond and other fixed-income funds, the tax bite is even deeper.

One way to tame the tax tiger is to own "tax managed" funds, says Morningstar analyst Christopher Davis. A well-run tax-managed fund, besides achieving good returns, will try to minimize taxable distributions with a variety of strategies, he says. Keeping turnover low is one approach, since frequent trades trigger capital gains. Other practices include limiting short-term gains, which are subject to higher tax rates, and harvesting losses to offset gains. Making a point of selling high-cost shares first can also cut distributions. As a result, many tax-managed funds can narrow the gap between pretax and after-tax returns to one percentage point or less over the long run, Mr. Davis adds.

A skillful fund manager will still outperform tax-managed rivals, warns Davis. In selecting a fund, "you can't let the tax tail wag the prudent investing dog," he adds. Still, by deferring taxes to the future, you make the most of the time value of money by compounding the value of reinvested gains.

Two fund families with a history of offering tax-efficient vehicles are Vanguard and Eaton Vance. Vanguard runs its five tax-sensitive funds with a combination of low-cost index investing and tax-minimization strategies. Vanguard's Tax-Managed Growth and Income fund, for example, has recorded slightly better returns than its flagship S&P 500 index fund on an after-tax basis and has never paid a capital-gains distribution. Eaton Vance's lineup of 11 tax-managed offerings cover a wider range of investment styles than Vanguard, but generally make more frequent distributions and carry higher operating expenses.

To find out if tax efficiency is a high priority for a fund, examine its prospectus, where it should be clearly stated, experts say. Then, compare a fund's after-tax and pretax returns, preferably over five- and 10-year periods.

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