Fund And Taxes - Underrated

The profound impact of taxes on the fund returns ia subject too long ignored. Ifact the dichotomy is that a portfolio manager’s performance is measured and applauded on the basis of pretax return – never mind that the IRS confiscates healthy share of it. As we've already noted, mutual funds must pass along to their shareholders any realized capital gains that are not offset by realized losses by the end of their accounting year. Mutual fund managers "realize" a capital gain whenever they sell a security for more money than they paid for it.

Fund managers must also distribute any income that their securities generate. Bond funds typically pay out yields, but so do some stock funds if the stocks they own pay dividends.

Unless you own your mutual fund through a 401(k) plan, an IRA, or some other type of tax-deferred account, you'll owe taxes on that distribution—even if you reinvested it (used the distribution to buy more shares of the fund). That is particularly painful if you have just purchased the fund, because you are paying taxes for gains you didn't get.

Turnover

A fund's turnover rate basically represents the percentage of a fund's holdings that change every year. "Turnover" is the gross proceeds from all sales divided by the total assets in the mutual fund. In plainer English, turnover represents how much of a mutual fund's holdings are changed over the course of a year through buying and selling.

It is ironic that a mutual fund’s high turnover excarbates the tax issue. Higher the turnover of a fund more taxes it can incur due to realized capital gains. This is more common for the small cap mutual funds. So the bottom line is a fund with turnover of 85% will be far more tax inefficient than a fund with turnover of 20%. Authoritative studies suggest that turnover rates would have to be reduced to 20 percent or less to engender a material lessening of the tax burden. Tax efficiency and maximizing money in the market that is compounding value is a key part of generating long-term, excess returns. In fact, when you calculate the effect of taxes, the margin of outperformance that many short-term oriented investors say they enjoy is whittled down. Although the standard defense is that you have to sell sometime, the reality is that if the money compounds over long periods of time and you capture lower tax rates for being a longer-term holder, on an after-tax basis the difference can be quite profound.

Alleviate tax headaches by following these tips:

1.      Ask a fund company if a distribution is imminent before buying a fund, especially if you are investing late in the calendar year. (Funds often make capital-gains distributions in December.)

2.      Place tax-inefficient funds in tax-deferred accounts, such as IRAs or 401(k)s. If a fund has a turnover rate of 100% or more, it's a good indication that limiting the tax collector's cut isn't one of the manager's objectives.

3.    Search for extremely low-turnover funds—in other words, funds in which the manager isn't doing a lot of buying and selling and therefore isn't realizing a lot of taxable capital gains.

4.   Favor funds run by managers who have their own wealth invested in their funds. These managers are likely to be tax conscious because at least some of the money they have invested in their funds is in taxable accounts. Fund companies now have to report to the SEC annually how much managers have invested in their funds.

5.     If you want to buy a bond fund and are in a higher tax bracket, consider municipal-bond funds. Income from these funds is usually tax-exempt.

6.      Consider tax-managed funds. These funds use a series of strategies to limit their taxable distributions. Vanguard, Fidelity, and T. Rowe Price all offer tax-managed funds.

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