Mutual Funds and Taxes

2007 - The Year Of The Tax

January 7, 2008

The Wall Street Journal notes 2007 may turn out to be the year of the biggest taxable fund distributions in history - eclipsing even 2000. In addition to explaining why this year may be the worst ever, the article notes some perennial tips to minimize the tax bite:

  • Consider index funds or exchange-traded funds. Broad-based index funds, which track benchmarks like the Standard & Poor's 500-stock index, rarely pass out capital gains because they don't trade much. For the most part, they vary the securities they own only when companies are added to or subtracted from their benchmarks.
  • Broad-based ETFs can do index funds one better. They have a special way of creating and eliminating fund shares that makes distributions even rarer.
  • Check out after-tax returns. The Securities and Exchange Commission requires funds to publish after-tax returns, which assume investors pay the highest applicable tax rate on dividend and capital gains. You may not actually have to pay the highest tax rate, but the figures are a good tool for comparing funds' track records.
  • Put active funds in your retirement account. If you are building a broad portfolio with several types of funds, consider keeping tax-friendly index funds in your taxable investment account and actively managed funds that trade more frequently in a 401(k) or individual retirement account.
  • Do some tax-loss selling. Remember how fund managers can use losses to offset capital gains? You can do the same thing. If you have fund shares or other investments that are worth less than you paid, you might "harvest" the losses by selling them."

We'd add our own MAXfunds tax tip that never seems to make the mainstream fund press: stop buying funds after they have posted big gains and focus on some out of favor categories that are sitting on tax losses from other investors' bad timing.

When investors buy the previous year's top performing funds, chances are that fund is going to pay a big taxable gain. Worse, this tax bomb often hits after the performance slips and investors leave, forcing the manager to make some sales to raise cash.

When investors buy a down-and-out-fund, the manager is already sitting on stocks that were bought at higher prices, and probably has realized a good deal of losses. The manager can use these losses to offset future gains. This is why your typical value fund has paid out higher distributions in recent years than many growth funds.

Of course the way this year is starting, investors might not have to worry about taxes at the end 2008 at all.


Ask MAX: Did My Fund Fall 41% In One Day?

December 7, 2007

Bobbie asks:

Can you please tell me what happened to the Fidelity Advisor Korea A (FAKAX) fund? It dropped 41% in one day. I have been holding this for many years and didn’t hear anything negative news that would have caused this."

On December 5th Fidelity Advisor Korea fund (FAKAX) paid out $3.06 worth of short term capital gains (taxed as income if you own the fund in a taxable account) and a whopping $13.03 of long term capital gains – a total of $16.09 or 42% of the fund price. These payouts are tax events – not actual drops like you see when fund investments fall.

Depending on what box you checked when you invested, you’ll either get a dividend check in the mail in the amount of 42% of your investment in the fund, or (more likely) the 42% dividend was reinvested for you into more shares of the fund. Either way you didn’t actually lose 42% of your money overnight. In fact the fund was actually up slightly on December 5th, adjusting for the distribution.

The bad news is if you own this fund in a taxable account (outside of an IRA or 401K), you’re on the hook for the taxes due on this amount come April 15th... the rest of this article»

Tough Tax Year Ahead

December 3, 2007

SmartMoney reports that mutual fund investors are in for a tough April 15th. Taxes paid by mutual fund investors, muted for years by the big losses of the early 2000s, are back with a vengeance:

Fund industry experts are predicting a double whammy this year that we haven't seen since the tech bubble burst. Not only will investors be staring at flat or dismal returns, but they'll also be faced with paying taxes on big capital gains distributions from the well-performing funds they held before the recent turmoil began. Lipper senior research analyst Tom Roseen estimates that investors may pay 20% to 30% more to the federal government than the $24 billion they shelled out last year. That means the typical investor, depending on how much they've saved in certain funds and what type of an account that money is in, could face a tax bill of thousands of dollars. 'We could easily hit the highest tab investors have ever seen,' says Roseen."

By law, funds have to distribute any taxable gains from investing to shareholders each year.

Your fund has profits and losses much like your own portfolio does. Funds can have losses from bad investments, gains in the form of short term or long term capital gains, ordinary income, and now, low tax dividend income.

Each year the fund accountants figure out how much income there is of each type. The tax liability is then passed on to the shareholders in the form of a dividend (the tax rate for each depends on the shareholder), which is why none of this matters in a tax deferred account like an IRA or 401(k).

Most of these fund distributions are made in December and many fund companies give estimates of these distributions on their websites in late November and early December, which can help existing and potential investors avoid some taxable gains.


See also:

Capital Gains Questions?

Tougher Tax Times Ahead for Mutual Fund Investors

How Mutual Funds Work - Capital Gains

Six Mutual Fund Tax Tips

Contact Your Congressperson

August 13, 2007

We here at obviously are pretty fond of mutual funds. After all, we've been encouraging readers of the site to invest in them since MAXfunds began way back in 1999 (though with more than a healthy dose of criticism and contrarian opinion). But while we think mutual funds are the best investment choice for just about everybody, they aren't perfect. One of their biggest drawback is the way investors in mutual funds are taxed.

When you invest in a mutual fund, you are essentially handing your money over to somebody else to invest for you. Because you lose direct control over your investments, you also lose control of your tax situation. If a fund manager sells a stock for a profit and has no losses to counter the gain, you are liable to pay a tax on that profit even if you haven't sold any of your shares in the fund. That means in any given year you could be hit with a monster tax bill clear out of left field - even if you didn't sell a single share of the fund.

Chuck Jaffe from Marketwatch reports on a law pending in Congress that would dramatically change how mutual funds are taxed.

The Generate Retirement Ownership Through Long-Term Holding Act of 2007 -- call it the GROWTH Act -- was introduced in June by Rep. Paul Ryan, R-Wis., effectively rehashing a sound proposal that he has put forth several times since 2003. The bill would allow fund investors to defer capital gains taxes on reinvested distributions until the fund is sold, a change that would simplify personal accounting, make fund investing more attractive and that would put funds on a similar tax plane as stocks."

The effect would be to turn every mutual fund portfolios into a kind of junior Roth IRA:

Allowing an investor to save in a fund without paying taxes on distributions indefinitely effectively creates the "lifetime savings account" that so many politicos have kicked around in recent years. For a buy-and-hold investor, it turns a "taxable fund account" into the equivalent of a traditional IRA, without the contribution limits. (Traditional IRAs require payment of taxes only upon withdrawal but allow investors to trade in and out of securities without generating a tax bill; in an ordinary taxable account, every trade is a taxable event.)"

For fund investors, we think this is a no-brainer. If you agree, why not drop your congressperson a line and tell them to get behind it. For many investors it would be a bigger investing tax break than the recent dividend tax cut.


Why World’s 3rd Richest Person Is In A Lower Tax Bracket Than You

June 28, 2007

Warren Buffett in the Washington Post confirms what I’ve suspected for quite some time: he is in a lower tax bracket than me.

Warren E. Buffett was his usual folksy self Tuesday night at a fundraiser for Sen. Hillary Rodham Clinton (D-N.Y.) as he slammed a system that allows the very rich to pay taxes at a lower rate than the middle class.

Buffett cited himself, the third-richest person in the world, as an example. Last year, Buffett said, he was taxed at 17.7 percent on his taxable income of more than $46 million. His receptionist was taxed at about 30 percent."

But how could he be? My income was significantly less than Buffet’s last year (and every other year for that matter).

The answer is because while all men may be created equal, all income is not. Relatively recent changes to the tax code have created even more favorable classes of income.

A dollar earned is taxed as income – at the local, state, and federal level. Income tax rates go up with higher level of incomes because we have progressive taxes – meaning you pay a higher rate the more you earn. Worse, social security and other payroll taxes are a huge percentage of your total taxable income if you earn a normal wage, but because they are largely capped these taxes become a very small percentage of your taxes if you earn $9 million.

But that only explains why many people are in such a high tax bracket. Why is Buffett in such a low bracket? A dollar passively earned is rarely taxed as income. Start a company and sell it for a billion dollars, and that billion dollars is long term capital gains, not income. Stock dividends are now taxed at lower rates than a clock watcher’s salary. And of course, social security and other payroll taxes don’t apply to passive income. Income from your checking account (0.50% interest rate…) is still taxed as income. As is CD, savings account, and bond income.

Unfortunately the money in our 401ks and IRAs will be taxed as income someday, not long-term capital gains or dividends. Hopefully our country’s financial situation won’t be so screwy that Congress will have to raise income taxes right when we need our retirement income.

While low taxes on passive investment income is good, most non-billionaires and those not partners in private equity outfits and venture capital firms would probably prefer a lower tax rate on income and a higher tax rate on investments – a simpler tax where income is income and there are no favorable ways to earn it.

Perhaps no tax on the first $25,000 and a 25% tax bracket on all income over $25,000 – no matter how it comes in. That way Buffett wouldn’t be in a lower tax bracket than his Secretary.


Tougher Tax Times Ahead for Mutual Fund Investors

April 20, 2007

The Chicago Tribune reports that taxes paid by mutual fund investors, muted for years by the big losses of the early 2000s, are set to rise again:

The opportunity is fading for your fund manager to offset capital gains from selling winners in the fund portfolio with losses from having sold losers during the market tumble earlier in the decade.

'The last four years, we have been on a tax holiday of sorts, and the party is over,' said Tom Roseen, senior research analyst at fund tracker Lipper, a unit of Reuters.

The stock market advance since late 2002, combined with higher interest rates and increased dividend payments by many companies, swelled the amount of capital gains and income distributions paid by mutual funds to their investors.

Moreover, the turnover of portfolios, as active managers buy and sell in an effort beat market benchmarks, has increased.

As a result, Lipper, in a 114-page report issued this week, estimates that taxable-mutual-fund investors, who hold funds outside tax-deferred savings accounts, such as IRAs and 401(k)'s, saw a 56 percent increase in taxes from 2005 to 2006, to $23.8 billion.

Most mutual fund investors reinvest income and capital gains. But they still must pay the tax, even though they have a buy-and-hold investment strategy, Roseen said. So-called tax loss carry-forwards from the years of the market slide are being used up or expiring, he noted. They expire seven years after the date of the sale."


Six Mutual Fund Tax Tips

April 10, 2007

Morningstar lists six ways you can make your mutual fund portfolio more tax efficient by minimizing your taxable fund distributions. Tax-efficient funds are those that make very few or relatively small taxable payments to shareholders; some funds try to keep trading activity low (minimizing realized gains which have to be distributed), some watch the way they buy and sell securities in an effort to minimize the tax burden to their shareholders.

  1. Invest in Tax-Managed Funds - The managers of tax managed funds take special care to keep taxable distributions to a minimum. They generally don't do much trading, and attempt to "sell losing stocks to offset winners elsewhere in the portfolio." Tax managed funds mentioned in the article: Vanguard Tax-Managed Growth & Income (VTGIX), Vanguard Tax-Managed Balanced (VTMFX), and Eaton Vance Tax-Mgd Value A (EATVX).
  2. Look for Closet Tax-Managed Funds - Many funds, such as Oakmark Fund (OAKMX) and Third Avenue Value Fund (TAVFX) don't officially call themselves tax efficient, but have managers that try to keep taxes low.
  3. Don't Forget about Index Funds - Index funds track indexes such as the S&P 500, and the people that decide which stocks are included in such indexes don't add or remove stocks from them very often. Because these funds tend to have low turnover, they are generally very tax efficient.
  4. Think about ETFs - Most ETFs track indexes, just like index funds do, and hence have low turnover. Low turnover usually equals high tax efficiency. In addition, ETFs unique structure minimizes taxable gains that have to be distributed to shareholders.
  5. Make Other Investors' Losses Your Gain - Mutual funds that have had particularly bad performance periods (think tech funds in 2002), can 'carry forward' those losses and offset gains for years to come. This is one we particularly like because it also means you are probably making a contrarian investment – investing where others have just lost money.
  6. Houseclean Your Own Portfolio - If you're planning on dumping a fund that has posted a loss, selling before December 31st will allow you to use the loss as a tax deduction on that year's taxes.


Of course, the most tax-efficient funds are the ones that stink when you own them, because they never distribute profits (there are none!) and often generate nice tax losses when you sell them.

See also:

Ask MAX: Capital Gains Quickies

How Mutual Funds Work - Capital Gains

How Mutual Funds Work - Capital Gains

December 14, 2004

We love mutual funds. Mutual funds provide cheap and easy investment diversification, they're easy to get in and out of, they're highly regulated, and they allow investors access to expert financial guidance at a low price. As investments go, we think that mutual funds are far and away the best option for the vast majority of investors in America.

But there are a couple of things about mutual funds that we don't like. Fund investors never know exactly what they're invested in. Mutual funds sometimes charge fees that are too high. Mutual funds can also hit investors with large and unexpected capital gains distributions. the rest of this article»

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