- The Washington Times - Monday, October 27, 2003

With stocks making a comeback, many mutual fund investors have been looking to jump back into the market. But they would be ill-advised to adjust their holdings without considering the tax consequences.

Federal taxes on average eat up about 2.5 percentage points, or up to 25 percent, of a taxable stock fund’s returns for investors in the highest tax bracket, according to Lipper Inc.

That’s even higher than the average 1.2 percentage point hit for expenses.

“Investors should make sure what best fits a portfolio and the tax ramifications as well, rather than buying or dumping at will,” said Tom Roseen, research analyst at Lipper.

In particular, investors right now should avoid buying into a fund before the company makes its capital gains distribution to ensure they aren’t unduly taxed on gains from earlier in the year. Other options include tax-managed funds that seek to lower taxable distribution and index funds with typically low turnover.

Investors don’t need to worry about tax-deferred accounts such as 401(k) retirement plans or individual retirement accounts, which aren’t taxed until investors withdraw the money.

But for other accounts, investors not only are taxed on their capital gain after selling shares, they also can be taxed for simply holding on to their shares.

That’s because investors are taxed for dividends and interest even if they reinvest them; they also must pay capital gains realized after a fund moves in and out of stocks and bonds.

In addition, fund companies distribute their accumulated capital gains between October and December each year. So investors shouldn’t buy right before the distribution — they could be taxed on gains they didn’t benefit from earlier in the year and then end up with a fund that’s worth less after the distribution payout.

Russ Kinnel, director of funds research at Morningstar Inc., said in many cases, capital-gains taxes will be small or nonexistent come April because heavy losses that funds racked up during the three-year bear market can offset this year’s gains.

But funds that have been particularly strong in 2003 and didn’t fare too poorly in previous years, such as gold funds, real estate investment trusts and small-cap funds, might be due for payouts. Those are the ones investors should be wary about from a tax standpoint if they are planning to buy between now and the end of the year.

Investors can look at Web sites such as Morningstar.com and Lipperweb.com to find a fund’s one-year, three-year and five-year returns, as well as the amount of share turnover, which tends to push up tax costs.

“If you’re buying a fund that has had a strong three-year positive return … and maybe has turnover of say, 50 percent, then you should check with the fund company to get an estimate of the distribution, if any,” Mr. Kinnel said.

“Conversely, if you’re in the market for a fund, you can look for funds that may have weaker longer-term returns or negative capital gains exposure,” he said. Those would have little or no tax liability.

There are other ways to minimize taxes.

Tax-managed funds seek to reduce distributions with managers’ techniques such as selling winners and losers together to offset the capital gains, while index funds typically have small distributions because they trade holdings less frequently.

Investors should also be mindful of the recent dividend tax cut. The new law makes it more advantageous to invest in dividend-yielding shares such as energy and financial services, rather than high-growth tech shares or REITs, which are not eligible for the tax benefit.

Still, advisers caution against an undue attention to tax efficiency.

They note that investors should also take into account overall returns, and whether a fund has a sound investment strategy and a reputable, long-tenured manager.

“I think the bottom line is the fund’s performance, not the tax questions, that really counts because a fund can be very tax-efficient but if it performs poorly, it won’t be very helpful,” said Barbara A. Comer, a certified financial planner in New Haven, Conn.


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