The Cruelest Tax Trap of Them All

Appalled by the idea of paying capital gains on mutual funds that lost money? Here are some tips that might just ease the pain

By Robert Barker

Nothing is more annoying about investing than the way Uncle Sam taxes mutual funds. Just ask those poor souls -- and there are plenty of us -- who paid capital-gains taxes on a mutual fund that lost money. But there's new research that suggests some ways to boost the odds that you'll gain as high an after-tax return as possible.

Fundholders are not only liable for ordinary income taxes on dividend payments, they must also pay capital-gains taxes -- even if they sell no fund shares. That's because tax rules require any net gains that a fund realizes on its investment portfolio to be distributed to shareholders. They, in turn, must pay the capital-gains tax, regardless of whether the fund's share price went up during the year.

A bill pending in Congress, HR 168 by Rep. Jim Saxton (R-N.J.), would limit this annoyance. But don't hold your breath waiting for legislative relief. Instead, you might do better to clue into some recent findings from the Schwab Center for Investment Research, an arm of discount-brokerage giant Charles Schwab (SCH ).


  As with all fund investments, whether in taxable accounts or such tax-deferred vehicles as 401(k) plans, the researchers note that it's important to pick a diversified group of funds with low expenses and a record of good pre-tax returns. In many cases, past performance isn't a predictor of future performance, but they discovered that funds with histories of tax efficiency predictably continue to minimize taxes. The reason: Portfolio managers rarely change their investment philosophies. So funds with good tax-efficiency records are the ones to look for.

And which funds should you avoid? Those that have suffered heavy recent withdrawals. "Large negative cash flows were indicators of future taxable distributions," says Jim Peterson, an author of the study and a Schwab Center vice-president. You can read the full paper by clicking here.

To reach these conclusions, Peterson, a former University of Notre Dame finance professor, and his colleagues studied after-tax returns of domestic stock funds over the 1981-98 period. As they set out in their research, they hypothesized that several variables, including a fund's riskiness, its portfolio turnover, and its investment style, might bear on after-tax returns.

They were surprised to find that portfolio turnover -- how much a fund trades in and out of stocks -- had no apparent influence on the after-tax return, despite a widely held belief that low-turnover portfolios are necessarily more tax-efficient. Peterson explains that turnover can be used to "harvest" capital losses, which can be used to offset gains. That way, an active portfolio manager can limit the fund's taxable distributions. A portfolio manager who didn't make those "harvesting" trades might have lower turnover, but at the cost of a lower after-tax return.


  The researchers also ruled out the possibility that funds enjoying large cash inflows would do better, just as funds with large cash outflows do poorly. The reverse case doesn't hold true, Peterson notes, because portfolio managers who are deluged with cash often have trouble finding enough good investment ideas to soak it all up. These funds may have lower tax bills, but heavy inflows dilute their ability to deliver high pre-tax returns.

Practically speaking, how can you use this research? Peterson suggests that once you've picked a diversified group of low-cost funds, you should also check their tax efficiency over the past three or five years. Tax efficiency, simply put, is how much of your fund's return is left over after you pay taxes on its dividends and capital-gains distributions. For example, if a fund's pre-tax return was 10% but after taxes it was 8%, its tax-efficiency ratio would be 80%. At the free portion of its Web site, Morningstar reports tax-efficiency ratios for the past 3, 5, and 10 years.

What's a good tax-efficiency ratio? It depends on the type of fund, but here are a couple of touchstones. In a field of 2,537 domestic equity funds given five-year tax-efficiency scores by Morningstar, the median tax-efficiency ratio was 76.3%. So you would want to do better than that. Just 244 funds, or less than 10%, had scores over 90%. That tells you 90% might be a good target.


  Learning about a fund's cash flow is harder, Peterson acknowledges. But here's a proxy: Because investors in the main tend to cash out of funds that have suffered big investment losses, Peterson thinks that it makes sense for taxable investors to avoid heavy losers because they're more likely to be suffering cash withdrawals and generating tax liabilities for shareholders.

It's easy to get lost in the weeds of funds and taxes. The key to finding your way to a portfolio of funds that will deliver good after-tax returns, however, is to keep your head up and focus on the big picture. Don't just look at pre-tax returns. Don't just look at tax-efficiency. Don't just look at turnover, investment style, or expenses. Weigh them all, and strike a balance.

Barker covers personal finance in his Barker Portfolio column for BusinessWeek. His column appears every Friday, only on BW Online.

Questions? Comments? Let us know at our interactive forum

Edited by Patricia O'Connell

Before it's here, it's on the Bloomberg Terminal. LEARN MORE