A Costly Afterthought for Investors: the Tax Man
BOSTON — Watch out for Uncle Sam: The wily, bewhiskered taker of taxes is winding a new way into the American purse.
Changes in the tax law underscore the imperative to stage a razor-sharp review of mutual-fund holdings and cut the federal government's take.
Washington has slashed the tax rate on capital gains on investments held more than 18 months to 20 percent.
In contrast, it taxes income by as much as 39.6 percent. So from a tax angle, stocks shine much more than bonds.
But that's where the simplicity ends: Investors ferreting out tax traps in their portfolios must look for the different ways to protect their wallets.
First, you won't get much help in tax reduction from mutual-fund managers. Even managers handling the highest-flying funds disregard the tax impact from their trades.
They leave such dreary details to investors, say financial planners.
But investors also tend not to consider the sticky palm of Uncle Sam except during tax time, say experts.
"People are just dimly aware of the consequences taxes play in total return," says Michael Haubrich, president of Financial Services Group Inc. in Racine, Wis. "They have a long way to go before they get to the level of awareness where they should be," he adds.
Consequently, mutual-fund investors usually end up trying to dodge the tax ax after it has fallen, say the planners.
For example, last year mutual funds investing in Asia hit investors twice. Mutual-fund share prices collapsed along with East Asia's currency and stock markets.
Then, fund managers had to sell underlying shares in order to meet a crush of redemptions. So at the end of the tax year they socked already staggering investors with heavy, taxable, capital gains.
Invesco Asian Growth, for instance, fell 38.5 percent during the year and then paid out more than 20 percent of its net asset value in December, according to Morningstar Inc. in Chicago.
Indifference to taxes among managers and investors will quickly evaporate after the next big market correction.
Managers will sell shares to meet redemptions and hand investors a big capital-gains tally at year's end, experts say.
But even the most benign, low-key fund operating in a calm market can lob a "tax bomb."
"Funds that are 'tax efficient' can carry a lot of embedded gains," says Otto Teiken, a financial planner in Minneapolis. "So if they have a sudden, big change of position, you can end up facing a big capital-gains bite."
Investors should avoid funds that change managers, Teiken says, as the new manager might make sweeping sales. Also, investors should stick to managers who closely adhere to their funds' objectives.
Fidelity's Magellan Fund shoveled about 25 percent of its assets into government bonds in early 1996, betting on a stock-market correction.
Magellan investors, however, thought their shares were in a large company growth fund.
When the Dow rocketed rather than plunged, Magellan's manager resigned and investors confronted a high tax bill.
With fund names and stated objectives sometimes misleading, low turnover can often flag a fund's level of tax efficiency, but not always.
Some managers who churn their portfolios offset gains with losses, according to Laura Lallos, a Morningstar analyst. But not everyone agrees.
"That's a bunch of nonsense," says Mr. Haubrich. "Many funds that try to balance gains with losses just end up managing losses and so they don't make money."
Haubrich views turnover as a key indicator of tax efficiency.
Consequently, index funds - those run by inactive managers who merely try to mimic the profile of a market index - often rank high as tax beaters.
Although tax efficiency is important, it should not be the first filter in selecting a mutual fund. Investors should review tax efficiency after drawing up a short list of prospective mutual funds, otherwise they might miss out on a fund with hefty pre-tax gains.
"You don't want to put the cart before the horse," says Ms. Lallos.
The Vanguard and Eaton Vance mutual-fund families feature funds devoted to tax efficiency.
Another option are "Spiders," Standard & Poor's Depository Receipts. These shares are sold on the American Stock Exchange and are part of a long-term unit-investment trust that tracks the price and dividend yield of the Standard & Poor's 500 Index.
But unlike a mutual fund, spiders allow investors to lock in a price at any time during the day, rather than only at the market's close.
They also make quarterly cash-dividend distributions and so give investors more control over capital gains.
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