- The Washington Times - Wednesday, April 11, 2001

Analysts call it the "double-whammy." First, the left jab many investors' mutual funds performed poorly in 2000. Then, the right hook come April 16, investors will be hit with capital gains taxes on those very same weak funds.

Many of the nearly half of all American households that own mutual funds are left staggering with large tax bills from fiscal 2000, even as they watch the markets dive further this year.

Robert Williams bought into a handful of mutual funds early last year. Even though the value of his portfolio has dropped 25 percent, he found out in November he would have to pay capital gains taxes totaling $25,000.

"You lose money like crazy, then you've got to pay taxes on capital gains that somebody else reaped the rewards of" when the market was up, says Mr. Williams, who owns Advanced Conservation Technologies Inc., a Gaithersburg water conservation business.

In 2000, of the more than 6,000 equity funds in existence, 2,841 had negative returns. Of those, 2,311 made capital gains distributions, according to Ramy Shaalan, senior fund analyst at Wiesenberger Thomson Financial, a Rockville fund research firm.

A capital gain is the difference between an asset's purchase price and selling price. Individuals realize capital gains when they sell anything from real estate to stocks.

Mutual funds present a unique situation for investors, because they give fund managers discretion to buy and sell stocks. That means that even though an investor may be inactive, holding onto a mutual fund, he or she can receive gains when the manager sells and realizes a gain.

Taxes on capital gains are usually 20 percent, depending on the tax bracket. Investors paid $39 billion in these taxes in 1998, according to the latest figures available from the Securities and Exchange Commission.

Mutual funds paid out an estimated $345 billion in capital gains in 2000, compared with $238 billion in 1999, reports the Investment Company Institute, an industry trade group. Not all of that is taxable, since about 65 percent of it goes into tax-deferred accounts.

But capital gains taxes are expected to reach an all-time high this year to match the highest gains ever on mutual funds in 2000, according to Wiesenberger.

Financial advisers say investors have a number of avenues they can take to avoid, or at least reduce, the impact of the taxes.

One solution is putting money away in long-term, tax-deferred vehicles such as individual retirement accounts and 401(k) plans. Several dozen congressmen have signed onto legislation that would increase the amount of tax-deferred dollars people can put into such accounts.

Redemptions roll in

Financial planners say the double bite from the tax man and the falling market should not have come as a surprise.

After the market began its dive last March, mutual-fund holders started to sell shares. Money managers who received those redemptions were put in a tight spot, since they were low on cash everything was tied up in the market.

So they began selling.

"As money managers try to better their positions and returns, they're generating capital gains," says Lambert Boyce, an accountant and financial planner with Clifton Gunderson in Baltimore.

The investors who held onto the funds were left with capital gains distributions, a piece of the profits made from selling stocks that are usually paid out at the end of the year. Though investors had cash in hand, many saw the value of their funds drop.

For example, Delaware Pooled Mid Cap Growth Equity lost 9.71 percent of its value last year. But the fund paid out 61.99 percent of its assets, or $6.43 per share, in distributions to its holders, an arrangement Mr. Shaalan calls "heartbreaking" in a report because investors will have to pay taxes on those gains.

Mr. Boyce says his clients are indeed disappointed.

"Our clients are having to pay a tax as their investments lose value, which is always a bitter pill," he says. "It does sort of drain their cash position and they feel poor."

Taxing reactions

Taxpayers are trying a variety of approaches to swallow that bitter pill, or to avoid it.

Stephan Cassaday, president of Cassaday & Co. in McLean, told his clients to sell their mutual funds before distributions came out last year.

He says he calculated the gain a client would have if he or she sold shares compared to the distribution. Either way, the money would be taxed, unless an individual's gains for the year were balanced by losses or unless the money was reinvested.

"You sort of sidestep the distribution" by selling, Mr. Cassaday says. He points out that the distribution has no real economic value anyway, because it comes out of the net asset value of the fund.

It is difficult to escape capital gains taxes on funds, says Paul Juergensen, a certified financial planner in the Washington office of the brokerage Advest, based in Hartford, Conn.

Some investors react by selling mutual funds and stocks to raise cash to pay those taxes, he says, though his clients have generally held onto their investments.

When Mr. Williams learned he would have big distributions coming on his mutual funds last year, he sold them to balance losses with gains and reduce his tax bill.

"Even though I felt on top of it, I missed one, and I ended up getting clobbered," he says.

His taxes are still lower than they would have been had he not sold, he says.

Robert Eitt was also unable to escape a capital gains tax hit this year.

He received $1,700 in distributions on a technology fund last year. The gains were classified as short term, which are taxed higher than those categorized as long term.

"At the same time, the fund itself was down by the end of the year, and this year is down a bit from where it was," says Mr. Eitt, a software consultant. He says the tax bill shouldn't make too much of a dent in his savings, including his children's college funds.

Barbara Orr, a McLean realtor, managed to avoid capital gains taxes with guidance from another certified financial planner and mutual fund specialist at Cassaday.

"We've invested in funds essentially that have created an income, but have not caused any capital gains or tax liabilities," she says.

Christopher Krell, Ms. Orr's adviser, says he minimized her tax bill by balancing gains and losses.

"We were able to realize capital losses throughout the year and proactively keep an eye on the realized gains in the portfolio," he says.

Mr. Krell says investors should find out what their distributions will be and make one of three choices. They can take the distribution and pay tax on it; sidestep it by selling and moving the money into another mutual fund; or sell out completely.

Mr. Boyce recommends a similar strategy, possibly selling funds before distributions are made. But he notes that investors, many of whom use mutual funds or stocks for retirement or college tuition for their children, should take a long-term view.

"You can't let taxes drive your investment decisions. You always have to look at these funds in the long term," he says.

One type of mutual fund takes essentially the opposite view, with tax efficiency as its primary goal.

"We as portfolio managers try to put ourselves in the shoes of the taxable shareholder," says Duncan W. Richardson, manager of the Tax-Managed Growth Fund at Eaton Vance Management in Boston.

He takes the same tack as Mr. Krell at Cassaday, balancing gains and losses.

Mr. Richardson says mutual-fund managers shifted into "hyperactive" mode when the market was flying. Turnover rates the amount of buying and selling in a given fund approached 100 percent, he says, which caused large capital gains distributions.

Tax-efficient fund managers do buy and sell, but at a lower rate, he says.

Other fund companies, such as J.P. Morgan and Vanguard, also offer tax-managed funds.

Knowledge is power

The Securities and Exchange Commission recently passed a rule that financial advisers and investors say will give them more tools to choose mutual funds and avoid paying huge capital gains taxes.

As of April 16, mutual funds will be required to disclose their pre-and after-tax returns so investors have an idea of how effectively tax-managed the fund is.

The government collected $39 billion in taxes in 1998 on $238 billion worth of mutual-fund distributions, according to the agency.

"Despite the tax dollars at stake, many investors lack a clear understanding of the impact of taxes on their mutual fund investments," reads the SEC's final ruling.

Mr. Williams is looking forward to the increased disclosure. He hopes the impact of mutual funds' tax costs will be incorporated into their ratings to help investors choose funds.

Mr. Richardson of Eaton Vance also thinks the new rule will be helpful especially since his fund will come out positively. In 2000, the company had no distributions on its six tax-managed funds.

Invest now, pay later

Aside from trying to balance gains and losses to minimize taxes, investors can squirrel money away in IRAs and 401(k)s.

Depending on their income, individuals can contribute up to $2,000 to an IRA and $10,500 to a 401(k) each year without it being taxed until it is redeemed upon retirement.

But financial planners, and now some congressmen, don't think those limits are high enough.

Reps. Rob Portman, Ohio Republican, and Benjamin L. Cardin, Maryland Democrat, introduced legislation in mid-March to increase the limits.

The Comprehensive Retirement Security and Pension Reform Act of 2001 would increase IRA limits to $5,000 by 2003 and 401(k) limits to $15,000 by 2005.

The bill is currently in the House Committee on Ways and Means, and should go through markup in the next few weeks, says Mr. Cardin's press secretary, Susan Sullam.

A similar bill passed in the House 401-25 last July, but got tied up in the Senate, she says.

Financial planner Mr. Cassaday says the proposed legislation would allow middle-income taxpayers to reduce their bills.

"Everybody in the United States should have the ability to put money away in a retirement plan without any hindrance," he says.

Sixty-five percent of the money individuals have in mutual funds is in tax-deferred accounts, says John Collins, managing director of public information for the Investment Company Institute.

Mr. Juergensen of Advest also thinks increasing limits is a good idea.

"I think that would be an excellent thing to do, because the more people are allowed to save on their retirement, the less they would be dependent on the government to do it for them," he says.

As Mr. Cardin points out in a press release, the savings rate fell to 3.8 percent last year, and he hopes to boost it with the bill.

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