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Mutual Fund and Tax Efficiency

By: Frank Armstrong

By: Frank Armstrong, CFP, AIF

About this time of year, millions of mutual fund investors begin getting some shocking news. Their funds are going to generate big tax bills for them next year.

Make no mistake about it, taxes on an investment portfolio are not a good thing. Every penny that leaves the field to march off to the IRS is a penny that can’t grow for our tomorrow. It’s gone forever. History!

How could this happen? Many investors didn’t do anything. They didn’t sell. To make matters worse, some of them even will have losses on their portfolios. Bummer!

As surely as night follows day, the press will pick up the story, citing the worst offenders, but tarnishing all funds in the process.

A little primer on mutual fund taxation is in order here. Every time a fund buys or sells a stock or bond, it realizes a capital gain or loss. Once a year they must distribute the net short term or long term gains or losses to the shareholders. In a different distribution they account for all net interest and dividend income. They do this in the form of a dividend distribution equal to the net taxable income of each type (1. interest and dividends, 2. long term gains, and 3. short term gains). Shortly thereafter the funds send a consolidated report to the IRS, with a copy IRS Form 1099 to the investor. The investor pays tax at his particular rate on the distributed income.

The distribution occurs regardless of the share price appreciation or depreciation. So, you could be down in total value of your investment for the year, but still be subject to a big tax.

Rather than take cash, most investors reinvest their dividends in new shares. So, until the 1099 rears its ugly head, they may not be quite so aware of the taxable distribution as perhaps they might otherwise be.

There is only one small piece of good news. Reinvested dividends add to the basis of your investment. So, when you finally do sell the gain is somewhat reduced. But, all in all, it’s painful. And it definitely cuts into your real investment returns.

Many wrap fee or individual stock managers seize on this tax treatment to claim an advantage over mutual funds. They are being deliberately obtuse. Individual stock or wrap fee managers have no great tax advantage over mutual funds given the same turnover in each. It’s turnover that generates the majority of the tax problems, not the investment format.

Some actively managed funds, wrap fee programs, and individually managed stock portfolios have turnover that exceeds 200% per year. At that rate almost all gains are converted to ordinary income with immediate taxation.

As a happy byproduct of their investment style, index funds have almost no turnover compared to managed funds. Without turnover, gains on appreciated stock escape taxation indefinitely. When the owner sells shares he receives capital gains treatment on the appreciation. The owner picks the date of the sale, a not inconsiderable advantage also. So, index funds are among the most tax efficient investments available. As individual investors have become interested in index funds, many of the funds have modified their operations and accounting practices to become even more tax efficient.

On the other hand, managed funds, individual stock managers, or wrap fee programs have a real problem when they try to become more tax sensitive. Presumably the manager is hired to trade stocks based on some strategy that will beat a passive benchmark or index. Notwithstanding the dismal record of active management, the manager is supposed to trade. If he thinks a stock is going down, should he hold it for tax reasons? If he thinks he has a great opportunity to buy a stock, should he base his sell decision on taxes or future performance expectations? These types of questions complicate the already discouraging task of trying to beat passive benchmarks.

This is not a trivial matter. The SEC will shortly require all funds to disclose their after tax returns as well as pre tax returns. The folly of high turnover will become readily apparent when after tax data gets widely circulated and compared.

For a variety of reasons-including taxes-we believe that index funds are the most appropriate investment wherever they are available. If you can’t get an index fund, buy a fund with low turnover, avoiding not only trading costs but major tax headaches as well. Along the way, the odds are that you will get better performance too.