12-Nov-2004
Although taxes can chew through your mutual fund returns when you invest in a taxable account, the new tax law of 2003 can trim your tax bill. The 2003 tax law is Washington’s gift to the long-term investor, offering substantial cuts in the tax rates on both capital gains and dividends. For investors using taxable accounts, buying and holding makes more sense than ever before.
Because distributions of capital gains and dividends are taxable in these accounts, you must pay taxes on all of your distributions, whether you receive them in cash or reinvest them in fund shares. Paying taxes on distributions can cost you 2 to 3 percentage points of return each year. To make matters worse, when you reinvest mutual fund distributions, you must come up with cash from somewhere else to pay the taxes on those distributions on April 15. However, if you buy shares in tax-efficient funds to begin with, and then choose the shares you sell wisely, you can minimize your pain at tax time.
Uncle Sam is watching you and your fund company, and come April 15, he wants his cut. As a fund investor, you should evaluate the tax ramifications of the following mutual fund actions:
• Selling shares of a fund that has increased in value
• Receiving interest from bond, money market, and REIT funds, distributed
monthly to fund investors and taxed as ordinary income
• Receiving capital gains from any fund, including municipal bond funds
• Writing checks from any type of fund account other than a money market
account, which triggers a sale of shares and is potentially taxable
• Exchanging (selling) shares in one fund family for another in the same
family. If the exchange is in a taxable account, you’ll owe taxes on any
gains
The 2003 tax law cuts corporate dividend and long-term capital gain rates to 15 percent through 2008. If the law isn’t renewed before 2008, these rates go back to their pre-2003 levels. Fund managers and investors who hold stocks and bonds for a year or longer shelter more of their own profits as a result of the new law. Likewise, fund managers and investors favoring dividend-paying stocks also benefit. The new law punishes short-term traders—managers or investors who hold stock, funds, or other assets for less than a year—with high tax rates.
Over time, the tax-savvy long-term investor’s returns will far outpace those of the short-term trader, as invested principal grows and compounds. There’s a big gulf between tax-aware managers who hear investors’ pain over high tax bills and the happy-go-lucky manager who reaches for high returns at all costs.
While stock investors cheered the 2003 tax cuts, investors in bonds and real estate investment trusts (REITs) weren’t so happy. Whether you invest in bonds and REITS directly or through mutual funds, you are taxed at ordinary income rates on their income. Municipal bond funds offer investors a haven from high tax rates. These bond funds make sense for investors who live in high-tax states and hit federal
tax brackets of at least 27 percent.
InvestinginBonds.com (http://www.investinginbonds.com/cgi-bin/calculator.pl) offers a simple calculator that helps you figure out whether you’re better off investing in taxable or tax-free bonds or bond funds. When you compare taxable and tax-free funds, remember to pick funds with similar durations and credit quality. Duration
measures a fund’s sensitivity to interest rate changes, whereas credit quality assesses the financial stability of the companies issuing the bonds inthe funds’ portfolios.
Tax Avoidance Strategies
All is not lost. There are plenty of ways you can minimize your mutual fund tax bill:
• Hold tax-inefficient mutual funds in 401(k) and IRA accounts when
possible.
• Contribute the maximum to 401(k) and IRA plans before investing in
taxable accounts. Although capital gains rates are low now, that won’t
last forever. Deferring taxes over a long period of time juices your
returns, adding to the powerful effect of compounding.
• Invest in tax-managed funds in taxable accounts. Most large fund families
offer several tax-managed funds with different investment options.
• Don’t make purchases in tax-inefficient funds late in the year. Funds
must distribute their capital gains, dividends, and interest before
December 31, so the shares you purchase in November or December are like buying the distribution and paying taxes on gains that you didn’t earn. It’s also a good idea to check a fund’s distribution dates
before buying and selling at other times. Don’t buy a fund right before a quarterly distribution or sell immediately after one.
• Check your potential gains in a fund before exchanging it for another
fund in the same fund family. Such an exchange is a sale for IRS purposes and could trigger capital gains. If your capital gains are large and you need the money, set aside 20 percent of your profits to pay taxes on the capital gains.
• Use losses to offset capital gains. If you own shares in a poorly performing fund, sell it to offset gains in other parts of your portfolio. Even if you don’t have gains, dump that dog and use up to $3,000 in losses to offset ordinary income. You can carry forward losses of more than $3,000 to future years.
