How to Avoid Tax Drag

Taxes cost mutual fund investors a fortune, but paying close attention can help you minimize those losses

From Standard & Poor's investing newsletter, The Outlook

If you invested in a taxable mutual fund in 2006, Uncle Sam thanks you.

In 2006 investors in taxable funds shelled out 56% more in taxes than in 2005, according to a 2007 study conducted by Lipper. A provider of fund information and analysis, Lipper estimates fund investors lost $23.8 billion to taxes last year, though that figure is shy of the 2000 record of $31.3 billion (a drop in tax rates helped).

In addition, mutual fund short-term capital gains distributions rose 66%, to $30.7 billion, in 2006. Although they're taxed at the lower 15% rate, Lipper estimates mutual fund investors paid at least $14.6 billion in taxes because of capital gains, up nearly 81% from 2005.

Four Products To Watch

As Lipper puts it: "Considering most mutual fund investors reinvest their distributions back into the funds, that is a large price to pay for a buy-and-hold strategy. Tax drag has a real impact on fund performance."

So what can investors do to minimize this so-called tax drag? Although this is important for investors to consider, Tom Roseen, author of the Lipper study, thinks the first order of business should be performance evaluations. "The idea is to find funds that are good strong performers and then make sure they're tax-efficient," he says. Lipper says the true measure of tax efficiency is the fund's ability to keep the greatest amount of aftertax wealth in the shareholder's pocket.

According to Roseen, there are four tax-efficient products investors should be aware of.

One option is pure index funds, such as those that invest in the Standard & Poor's 500-stock index. These funds, Roseen says, have the propensity to keep taxes low. This is because there's not a lot of turnover, so the funds don't pass through much in the way of long-term or short-term capital gains.

Expenses in these funds are typically low, too. "These funds keep two of the three major drags on performance in check," Roseen says. "The other is load."

Check Out ETFs

Roseen says no-load and institutional funds outperform loaded funds primarily because of expenses. Front-end load funds typically charge a fee for account servicing of 0.35%, but that figure jumps to 1% for back-end and level-load funds, Roseen points out.

One reason investors buy back-end or level-load funds is that they don't expect to be in them for more than a year, typically. Since a front-end fund might charge 5% at the start, it could make sense to buy a fund that wouldn't charge a fee until a future date, for instance.

Another tax-efficient option is exchange-traded funds (ETFs). As with index funds, turnover is low, and they also provide in-kind redemptions. Generally in a mutual fund, if an investor redeems $2 million of an investment, the portfolio manager has to sell securities to meet the redemption, Roseen says. The capital gain from selling the securities stays on the funds' books and is passed through to the investors.

With an in-kind redemption, large financial institutions holding large blocks of shares exchange these for the actual securities that make up the ETF. This does not trigger a capital gain or a loss.

Roseen says municipal bond funds are the ultimate in tax efficiency since the income distributions aren't taxable. Taxable funds' distributions could be taxed up to 35%, the highest tax bracket, he says.

"Muni funds might underperform slightly on a total return basis, but after taxes, they outperform on an average of 1% to 2%," Roseen says. "We would probably put taxable bond funds in qualified plans— a 401(k), for example, because they have the tax shelter and they have good returns."

Don't Make Tax Considerations No. 1

Investors in bond funds should determine whether to invest in a taxable or tax-exempt fund after first considering their tax bracket. The higher the bracket, the more an investor must earn to equal or surpass a yield from a municipal bond fund. Experts say muni funds are typically more appropriate for investors in the two highest tax brackets (33% and 35%).

Although Roseen says never to put tax considerations ahead of performance when selecting a financial product, he points out that tax-managed funds are often more tax-efficient than their taxable brethren. Over rolling one-year periods, the tax managed funds outperformed non-tax managed funds at least half of the time. On an aftertax basis, that figure jumped to 70%.

The Lipper study found the tax drag has receded over the last few years, but Roseen says there are concerns the taxes paid by investors in mutual funds will be a "debilitating factor again on aftertax fund performance."

According to Lipper, over the last 10 years, taxable equity fund investors surrendered about 1.4% and taxable mutual fund participants gave up 2.3% during an average year to taxes. "With market pundits forecasting more moderate returns, investors will benefit from paying closer attention to the different components of drag on performance (load, expenses, and taxes) in order to eke out greater returns," Lipper says.