Making Sure Uncle Sam Doesn't Punish Your Portfolio

Paying taxes isn't any fun when you make money on your investments. But it's especially galling to owe Uncle Sam for investments that have declined in value. That's the grim predicament many mutual-fund holders are puzzling over as Apr. 15 approaches.

The reason this occurred: Funds that performed poorly in last year's volatile stock markets faced net shareholder redemptions, forcing them to sell holdings. In many cases, managers chose to unload highly appreciated stocks without taking compensating losses, exposing shareholders to stiff capital gains. Twentieth Century Growth Investors had a huge capital-gains distribution of $3.22 per $21.72 share, which resulted in an estimated 1994 aftertax total return of -5.6% for investors in the 31% tax bracket (compared with a pretax return of -1.5%). Results like these "add insult to injury," says William Klipp, chief operating officer at Charles Schwab Investment Management.

"DOUBLE-EDGED SWORD." Mutual-fund investors can't control capital-gains distributions. The best you can do is be alert in tough years such as 1994 and try to get out of the fund ahead of the distribution. Ask the company in November if it expects to make a large capital-gains payout. You can always return to the fund later. You may be able to avoid taxes in the future by seeking out tax-efficient funds. Or, if you manage your own portfolio of stocks, there are plenty of strategies you can use to help minimize your tax burden.

When selecting funds, be sure to compare pretax and aftertax returns, which can often be dramatically different. Although, as 1994 shows, fund taxes vary from year to year, the strategies of some managers dictate the fund's general tax-efficiency. BUSINESS WEEK provides pretax and aftertax returns in its annual Mutual Fund Scoreboard (BW--Feb. 6). To arrive at a figure you can use to compare two funds' tax efficiency, divide the aftertax by the pretax return.

Also, check to see if a fund is carrying a high percentage of unrealized capital gains (also in BUSINESS WEEK). Don't avoid a fund just because it has a high untaxed gain. It could be a result of the fund's winning, low-turnover strategy. Capital-gains taxes are "a double-edged sword," explains Maryanne Roepke, vice-president and treasurer at Twentieth Century. "You want a fund to be successful, but you don't want to pay for the gain."

Mutual-fund companies generally don't like to cramp their portfolio managers' styles by requiring them to consider tax consequences of trades. So you won't find a lot of fund managers who seek out losses simply to use as a deduction against gains. "The feeling here is you manage funds primarily to achieve the best returns, without being restrained by tax considerations," says T. Rowe Price spokesman Steven Norwitz. Besides, funds have little incentive to limit tax exposure, since most people judge funds on pretax returns and many shareholders use funds in tax-deferred retirement accounts.

But some fund sponsors are taking small steps to improve tax efficiency. A common technique among private money managers to limit gains is to sell the shares first for which they paid the most (those with the highest cost basis). But many mutual-fund managers used to ignore this simple step and account for sales on an average-cost basis. Some companies are making the switch to target the highest price shares for sale first. T. Rowe Price, for example, changed the policy for its funds earlier this month, says Norwitz. Strong Funds adopted tax-efficient sell procedures last year.

Similarly, mutual-fund investors should sell their highest-priced shares first. To do this, you must write to the fund company in advance and identify the shares before you cash out. If you're in a high income-tax bracket, try to hold stocks for at least a year to benefit from a lower capital-gains rate (28%). Marginal income-tax rates, which go as high as 39.6%, are levied on gains in stocks held less than a year.

Primarily, tax efficiency in mutual funds comes down to low turnover. In general, value funds tend to have lower turnover than growth funds, although there are plenty of exceptions. Index funds, which hold a weighted portfolio of every stock in a market average like the Standard & Poor's 500-stock index, are among the most tax-efficient. The average actively managed fund has about a 75% turnover rate, which can be 6 to 10 times higher than an index fund, says Vanguard. Before tax, the 500 Portfolio of Vanguard Index Trust did better than 78% of all funds over 10 years. Aftertax, its returns place it higher than 85% of all diversified equity funds, says John Bogle, Vanguard's chairman.

NO BITE. Recently, a few fund companies have built on the basic tax efficiency of index funds. The Schwab 1000, Schwab Small Cap, and Schwab International index funds are all managed with the express intention of deferring capital gains. Unlike most index funds, appreciated stocks stay in the portfolios indefinitely, even if they drop out of the index. The funds will sell stocks that don't belong when they have losses that can be used to offset gains, Klipp says. The Schwab 1000 had only a 3% turnover rate last year.

Last July, Vanguard introduced its Tax-Managed Fund, which is made up of three portfolios: balanced, capital-appreciation, and growth-and-income. Each portfolio is based on indexes, so the turnover is low. Managers also sell holdings to realize losses that can offset gains. Plus, Vanguard imposes a small redemption fee on shares held less than five years to discourage trading. The minimum investment is $10,000.

The problem with tax-efficient funds is that capital gains inevitably come due when you sell your shares. But there is one way to avoid paying the taxes: When you donate highly appreciated stock to charity or leave it as an inheritance, the equities are automatically stepped up in basis to the current share price. Your beneficiaries or the charity can then sell without facing a tax bite.

Of course, you get the most control over paying capital gains when you assemble your own stock portfolio and can plan when to buy and sell holdings. If you are tempted to sell a winner to buy another stock, you had better hope the potential gain on the new stock will make up for the taxes you'll owe, as well as transaction costs. When you take a gain, look for securities with losses that you can "harvest" as a tax deduction. Up to $3,000 in excess losses is deductible against income each year, and the rest can be carried forward to future years.

Sophisticated investors may want to reduce their tax burden by "swapping" holdings. This is essentially a way to take a loss in a stock you still like just to get the deduction--so it's often used at the end of a year. You sell the stock, then immediately buy a similar holding. If you want, after a month, you can buy back the original stock without running afoul of "wash sale" rules, which prohibit investors from taking a tax deduction for a loss in a stock they repurchased within 30 days. Before you try it, make sure the tax savings will make up for the transaction costs incurred.

MODEL INVESTORS. Private investment advisers and brokers should automatically implement many of these tax-saving strategies. And some firms are using their strength in this area as a selling point. Last September, J.P. Morgan launched "Tax-Aware Equity Management" for private-banking clients with at least $5 million invested with the firm. Large-cap stock portfolios are run through a computer model containing analysts' forecasts for more than 600 companies. Before a trade is executed, the model checks to make sure the gain forecast for the new stock is big enough to make up for the tax and commission costs of selling the old stock. It also suggests other stocks that can be sold for an offsetting loss. Morgan expects its forecasting abilities and speedy, tax-efficient trading to allow it to return 1% to 2% more than the S&P 500 after taxes.

Whether you purchase stocks or mutual funds, you shouldn't let tax considerations be the driving force behind your investment plan. Real returns are what count. But if you keep taxes in mind, you can enjoy handsome long-term results without letting Uncle Sam crash your party.

How to Pare Taxes on Stock Gains

Sell appreciated securities only when necessary to defer capital-gains tax as long as possible.

-- Try to hold onto a stock for a full year so it will be subject to capital-gains treatment. Profits from stocks held less than a year are taxed as income, often at a higher rate.

-- When you sell securities at a gain, look to sell others with offsetting losses. Up to $3,000 of excess losses is deductible against ordinary income annually, and the rest can be carried forward to future years.

-- If you are reducing your position in a stock that has appreciated, sell the shares you paid the most for first, so your capital gain will be smaller.

-- If you plan to leave an inheritance or give to charity, designate your most highly appreciated stocks. Equities are automatically stepped up in basis to the current price level when they are given to charity or left to beneficiaries in a will.

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