Pay Less Tax on Your Funds
Monday, October 6, 2008; 12:00 AM
The nip of autumn is in the air, and that means it's time for many mutual fund companies to announce their capital-gains distributions. This has been a wretched year for the stock market, but because of the way funds work, you may still be on the hook for income taxes nextApril. Whether the market is up or down, it is a good time to consider the impact of taxes on your funds' returns and to look at funds that care about your tax bill.
Big bucks are at stake. The Investment Company Institute, the fund industry trade group, reports that some $6 trillion of fund assets rest in taxable accounts. In 2007, estimates research outfit Lipper, funds distributed a record $150 billion in capital gains, on which investors paid a record $34 billion in taxes.
Lipper calculates that the tax take for the average fund in 2007 was 1.7 percentage points, equal to 24% of the gain of the average U.S. stock fund that year. Research shows that over the decades, the hit for taxable investors in actively managed funds has averaged two points, or 20% of the stock market's long-term gains. That leakage exceeds the combined loss to commissions and management fees.
The rules for funds and taxes are complicated. Unlike capital gains from stocks, which are triggered and taxed only when you sell the shares, funds are required to pay out to shareholders essentially all earnings realized each year, as well as dividends they have collected from their holdings. Your fund may have lost money this year yet generated taxable distributions because it sold profitable positions.
Missing from the debate
What most discussions of funds and taxes neglect, however, is that distributions lower your future taxes. If you reinvest your distribution, as most investors do, you increase your tax basis, the figure on which you determine gains or losses when you sell your shares later (see The Scoop on Fund Distributions). If you don't reinvest, you will collect less when you sell than you would if there had been no payout. So in comparing tax-efficient funds with funds that pay large distributions, the issue generally isn't one of paying now as opposed to paying never; it's paying now versus paying later.
The bite from paying taxes to Uncle Sam on a regular basis is not trivial. Say you have a portfolio of $100,000. If you lose two percentage points a year to taxes and the portfolio compounds at 8%, you will have $126,000 after three years. If the money compounds at 10%, your funds will be worth $133,000, only 5.5% more than what you earned with an 8% annual return. But look at what happens if you let that $100,000 portfolio ride over 30 years, which is less than an investing lifetime: At 8% annualized, the portfolio expands to $1 million, but at 10% annualized, it compounds to $1.75 million, 75% more than if you lost two points to taxes each year.
Joel Dickson, of the Vanguard Group, says you should build tax efficiency into your long-term investment plan. After all, unlike stock-market or interest-rate movements, tax efficiency is a relatively controllable part of your investment program. And you should consider carefully whether each investment should reside in a taxable or tax-deferred account.
Ponder this long-term investment strategy for the stock portion of your taxable portfolio: Sock away a chunk of your core stock portfolio -- whether it's $10,000 or $500,000 -- in funds that minimize corrosive losses to taxes and hold them for an investing lifetime.
To understand the potential of such a strategy, consider a lofty ideal: By buying and holding funds that never pay out capital gains, you never pay capital-gains taxes. Under current law, the IRS offers two wonderful tax breaks for investors who master the challenge of compounding but not realizing capital gains over an investing lifetime: stepped-up basis and charitable contributions.
Under the step-up rules, the cost of an investor's stocks or funds is stepped up to their market value when he or she dies. Thus, if a $100,000 portfolio grows to $500,000 over time, your heirs' basis is stepped up to $500,000, and the $400,000 of capital appreciation goes completely untaxed.
If you donate appreciated funds to charity, you enjoy a double benefit. Say the fund's value has grown from $10,000 to $50,000. You pay no tax on the gains, and you can deduct the full value of the gift ($50,000) on your taxes. The donee receives a $50,000 asset with no capital-gains tax liability.