One silver lining from the stock market's three-year slump was taxes. Because investors made few if any profits, their portfolios offered Uncle Sam the slimmest pickings in years.
Now, with the market's recovery, the tax monster is making a comeback. And mutual-fund owners should pay close attention, experts warn, because even with lower rates on dividends, taxes still represent the biggest drag on their investment performance, says a recent study from Lipper Inc. That's bigger than management fees and even, over time, sales charges.
"Taxes have become less important, but they're about to rear their ugly head again," says Tom Roseen, senior research analyst at Lipper Inc. and author of the study on the impact of taxes on mutual funds.
While there's no way of avoiding the tax monster completely, advance planning coupled with careful picks in mutual funds can ease its bite, he adds.
Until this year, the tax outlook was good in a perverse sort of way. Because of the bear market, many mutual funds sustained substantial losses from 2000 through 2002, Mr. Roseen explains. And while some of those same funds recorded handsome gains last year, shareholders paid little or no taxes on the gains because the fund companies were able to offset most of the gains by carrying forward losses from the previous three years.
That could change this year, Roseen says, because many of the funds used up their losses last year. So any gains this year may be taxable, unless the funds are held in a tax-deferred plan like an IRA or 401(k).
The government's take can be enormous. Owners of taxable funds lose anywhere from 2 to 2.5 percentage points of their return because of federal taxes alone, according to the Lipper study. As a result, owners of stock funds are surrendering up to 24 percent of their returns to the Internal Revenue Service. For owners of bond and other fixed-income funds, the tax bite is even worse: up to 45 percent, the study found.
"People are going to wake up and say, 'I thought you said I got an 8 percent return this year,' but they're only going to be getting 6 percent or less," Roseen says.
Last year, considered a light year in terms of the tax burden, fund owners still funneled an estimated $6.5 billion to federal coffers alone. The Lipper study didn't include state taxes.
Time to adjust
Nevertheless, there are ways shareholders can minimize that tax bite, experts say. With almost six months left in the year, investors still have time to check their taxable portfolios and find ways to manage the taxes they may owe.
"People start talking about taxes in December," Roseen says. "That's way too late."
To begin with, investors should pay close attention to the funds that they buy, says Steven Enright, a financial planner in Old Tappan, N.J. For example, mutual-fund managers frequently buy and sell securities within their portfolios. When they sell a stock at a profit, the fund will realize a gain. However, if investors buy the fund - particularly if they do so late in the year - they may have to pay taxes on gains incurred before they bought the fund.
"If it has a large built-in capital gain, you will want to avoid that fund," Mr. Enright says. Independent services such as Morningstar provide capital-gains information, but you can also get it from the fund companies themselves, he points out.
Investors also may want to consider funds that are more tax-efficient - that is, funds whose managers try to minimize their tax burdens. Index funds, for example, generally buy and hold a representative sample of stocks or bonds in an index, like the Standard & Poor's 500 stock index or the Lehman Brothers Aggregate Bond Index. These securities aren't sold very often, so capital gains are minimized.
Another option may be "tax-managed" funds, says James Pinney, a financial planner in Cambridge, Mass.
In general, these funds try to harvest losses in their portfolios to offset gains whenever possible. Some, like Vanguard's Tax Managed Growth and Income Fund, also have redemption fees to discourage short-term investors who could quickly and frequently pull money out of the fund, causing it to realize gains.
Other tax-managed funds track different classes of investments, such as small-company value or large-company growth stocks, Mr. Pinney says, so investors can diversify among classes.
Investors can also use a similar harvesting strategy with their own fund holdings. For example, by now you may have a pretty good idea which funds are likely to finish the year with gains and which ones are likely to suffer losses. By selling the losers this year, you can put those losses to good use for your winners.
"You can find a fund that you know is a loser right now," Roseen says. "If you wouldn't buy it again anyway, you can take this opportunity to sell that fund to offset any gains from other funds. That's an easy way to tax harvest."