Funds scramble to make tax-free annuities fit IRS ruling

''What the mutual funds have joined together, let no IRS ruling put asunder.'' That seems to be the theme for several mutual funds these days, as they work to recover from a September ruling by the Internal Revenue Service. The decision struck down one of their more innovative and fast-growing products. Now, the funds are trying to come up with new products that will satisfy both their customers' desires for tax-free savings and the IRS.

The products in question often carry colorful names like Galaxy, Spectrum, Rainbow. In the industry they are more commonly known as ''wraparound annuities.'' These tax-deferred investments take an annuity from an insurance company and wrap it around a mutual fund.

To invest in one of these funds, the customer sends the money through a broker to the mutual fund company, which uses it to purchase a retirement annuity from its insurance company partner. The fund, however, controls the investment portfolio.

Because the money is still technically held by the insurance company, dividends from the account are not taxed until withdrawn. If held to retirement, the tax rate would almost certainly be lower. And the investor can still move money from one type of fund to another, depending on whether he thinks stocks, bonds, or money markets are the most suitable place to park retirement cash.

If the customer passes on before retirement, the original investment, plus any earnings, is paid to the heirs as a tax-free death benefit.

Next to money market funds, the wraparound annuities have been one of the fastest-growing areas in the mutual fund industry. In less than three years, they gathered several billion dollars in deposits; this year alone, it is estimated they took in over $1 billion.

But all that changed on Sept. 25, when the IRS came out with Revenue Ruling 81-225. The ruling said that when shares are available to investors for switching from one fund to another, the insurance company doesn't really have control over them. And if the insurance company doesn't have control, the earnings aren't tax-free.

While this part of the ruling was not totally unexpected, mutual fund executives were surprised by another part: The decree was made effective retroactively, to cover deposits made after Jan. 1 of this year, nearly nine months earlier.

The ruling did mean, however, that funds fortunate enough to have been created by an insurance company, like Kemper, and those set up by an insurance company, like Keystone (owned by the Travelers Group) could continue offering annuity funds. The others got to watch deposits shrink.

For instance, at Massachusetts Financial Services (MFS), credited with helping invent the wraparound annuities when it joined with Nationwide Life Insurance Company to introduce Spectrum, the annuity took in $23 million in deposits in October, about half its normal rate, said Claude Thomas, president of the sales division at MFS.

At Putnam, the ruling ''caused us to withdraw our product,'' Putnam vice-president Gordon Evans said simply. He was particulary concerned about the retroactive part of the ruling. It leaves customers with two choices, he said. Either they can refuse to pay taxes on the income earned in the funds from January through Sept. 25 and fight the issue in court, possibly risking penalty and interest charges, or they can figure how much they deposited and how much they earned, then pay up.

So the mutual funds have been busy devising new products. Last week MFS and Nationwide came out with their first one, a tax-free money market fund. Assets in the fund are actually held and managed by Nationwide as an annuity. MFS just acts as administrator and wholesaler of the fund, MFS spokesman Roger Carlock said. Before, MFS managed the Spectrum funds, Mr. Carlock said.

In the near future, MFS and Nationwide plan to introduce a bond and stock fund, also managed by Nationwide, to satisfy the IRS rules.

At Keystone, says Robert Sharp, chief executive officer, ''We were one of the lucky ones.'' Keystone did some restructuring to meet the IRS rules, but it is back with a money market fund, a money market-option income fund (with 90 percent of the investment in money market instruments and 10 percent in options) , and a stock and bond fund. Being owned by the Travelers gave Keystone the advantage of still being able to sell and manage the fund shares on its own, Mr. Sharp said.

Meanwhile, the Investment Company Institute is doing what it can to get some fresh interpretations of the ruling, if it cannot get the ruling overturned altogether. ''We've been talking to the Treasury and the IRS about getting a clarification of the ruling,'' Matthew Fink, an ICI lawyer, said.

For instance, he wondered, does the ruling permit an insurance company to set up the account and have the money managed by a mutual fund? ''There are about eight different permutations of that theme,'' Mr. Fink said.

While the ruling was quite confusing to the industry, he said, ''the investor does have some products around if he wants them.'' But in general, until there is some clarification, ''Everything is all messed up.''

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