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Keeping Uncle Sam Out of Your Pocket

By: Richard Feldman

By: Richard J. Feldman

Investing money is all about keeping your eye on the prize. In the real world individuals are hard pressed to spend theirs before tax returns. Therefore investors who manage their funds in a taxable account should develop a measuring stick that they can compare their results to. To manage these assets as effectively as possible investors have to be aware of the impact of taxes on their investment results. Until recently after-tax results were not made public by mutual fund companies making it difficult to compare results on an after tax basis. Recent studies by Morningstar and Lipper show that taxable investors may be giving up as much as 20 – 25 percent of before tax return to taxes. Recent tax cuts on dividends and long-term capital gains will mitigate these figures to a certain extent but taxes still remain the biggest drag on long term investment performance. Tax managed mutual funds have been developed to combat this problem and focus on after tax results through specific trading strategies and portfolio management techniques. These funds first were introduced in the mid 1990s but have flourished in recent years.

Mutual Fund Taxation

As a mutual fund owner there are two components of investment return:

1) Income: Income is derived either as interest or dividends and both have different tax consequences. Qualified stock dividends enjoy a 15% federal tax bracket where as income is taxed at the individuals federal tax rate.

2) Capital Gain:the increase in the value of the price per share of stocks held in the fund portfolio. If the fund manager sells stock in the funds portfolio that has increased in value a capital gain will be realized.

At the end of a mutual funds fiscal tax year which is typically August income and capital gains/losses are computed for shareholders. Distributions then are distributed to shareholders in December.

Mutual Funds that hold stocks for a long time or have low portfolio turnover can escape taxation on the unrealized appreciation on the securities they own. The longer you can delay paying taxes on the unrealized appreciation the greater the compounding effect on total returns.

How much of a drag are taxes?

The average U.S. large-cap stock fund posted an average pre-tax return of 10.0% in the 15 years ending June 2003, but only 7.7% after taxes on distributions according to Morningstar. A study done by Lipper in 2002 shows that investors needlessly give up as much as 23% of returns to taxes.

Tax Managed or Tax Aware Funds

There are a number of ways to measure the effectiveness of mutual funds at managing the tax impact for investors. Typically after tax return divided by before tax return will reveal tax efficiency. The higher the ratio the more tax efficient the fund. Tax efficiency has a very high correlation to turnover in mutual funds. The lower the turnover the higher the tax efficiency. Although there are some funds that have high turnover that are still tax efficient due to tax efficient trading strategies. Mutual funds manage taxes through several tax management techniques within the mutual fund:

  1. Avoid Short-Term Realized Gains: Short Term Capital Gains are the most prohibitive due to the fact that investors are taxed at their ordinary income tax bracket which can be as high as 35% on the federal level. The difference between long term and short term capital gains make realizing short term gains punitive to investment results.
  2. Keep Turnover Low: Turnover measures trading volume of stock transactions in mutual funds. A turnover ratio of 100% means that the portfolio manager has turned over 100% of a portfolio in a fiscal year. Often a mutual fund that has high turnover ratios are tax inefficient and have high realized short and long term gains. Low turnover funds such as index funds typically are very tax efficient because stocks are not sold unless they are dropped from an index. Some tax managed funds will have higher turnover ratios than other based on the asset class they are invested in ( Large Cap, Small Cap, International).
  3. HIFO (Highest In First Out): Typically tax managed funds use sophisticated accounting tools to track the purchases of the securities within a portfolio. Typically portfolio managers will purchase several lots of stock with varying cost basis to the funds. Typically when a fund wishes to sell a position or pare a position they will sell funds with the highest cost first generating a tax loss or the lowest capital gain available.
  4. Tax Loss Harvesting: Loss harvesting refers to realizing losses by selling shares that have fallen below their original cost to generate capital losses. Capital losses are created whenever the loss is greater than the transaction cost associated with generating that loss.
  5. Qualified Dividends: Tax-managed funds will look to invest in securities that meet the new qualified dividend rules. Taxation of qualified dividends will be taxed at the 15% rate if you are in the a bracket higher than 15% or they could be taxed at a 5% rate if you are in the 10 or 15 percent bracket.

Summary

Taxes matter. Individuals are reminded every April 15th how much they matter. Taxes have a substantial impact on wealth generation. It is hard to believe that investors focus so little attention on the largest known drag on taxable investment performance. Tax managed funds are becoming more popular with the advent of publishing after tax results but still make up an extremely small portion of the total taxable investment universe. People think that there is not much they can do about taxes and that Uncle Sam will take its piece of the pie. There are a lot of unknowns in the investment universe but taxes are not one of them. Tax rates are known in advance and therefore can be managed effectively via the use of tax managed funds in each specific asset class where available.