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Course 104
Mutual Funds and Taxes

Introduction

Thus far, we have lauded mutual funds' virtues. They don't require a large up-front investment. They're professionally managed. They're easy to buy and sell. And if you shop carefully, you can limit how much you have to pay to own them.

But there is one thing that mutual funds may not be: tax-friendly. In the following section, we'll explore reasons for this weakness and examine the ways in which you can minimize its impact on your bottom line.

Funds, Capital Gains, and Income

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. Conversely, they realize a loss when they sell a security for less than the purchase price. If gains outweigh losses, the managers must distribute the difference to fund shareholders.

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.

As you may recall, when paying out capital gains or income, funds multiply the number of shares you own by the per-share distribution amount. You'll receive a check in the mail for the total amount of the distribution. Or, if you choose to reinvest all distributions, the fund will instead use the money to buy more shares of the fund for you. After the distribution is made, the fund's NAV will drop by the same amount as the distribution. Fund companies often make capital-gains distributions in December, but they can happen any time during the year.

Distributions and Taxes

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.

Let's use an example to illustrate. Suppose you invest $250 in Fund D on Monday. The fund's NAV is $25, so you are able to buy 10 shares. If the fund makes a $5-per-share distribution on Tuesday (which means you have been handed a $50 distribution), and you reinvest, your investment is still worth the same $250:

Monday 10.0 shares @ $25 = $250
Tuesday 12.5 shares @ $20 = $250

The trouble is, you now owe capital-gains taxes on that $50 distribution. The current long-term capital-gains tax rate is 15% for anyone in the 25% or higher bracket and 5% for those in 10% to 15% brackets. If you're in the higher tax bracket, you'd have to pay $7.50 in taxes on that long-term capital gain. (Shorter-term capital gains are taxed at a higher rate.)

If you immediately sold the fund, the whole thing would be a wash, as the capital gains would be offset by a capital loss. The distribution lowers the NAV, so the amount of taxes you would pay would be lower than if you sold the fund years from now. Still, most investors would rather pay taxes later than sooner. And we're guessing that if you just invested in the fund, you weren't planning to turn around and sell it right away.

Funds occasionally can add insult to injury by paying out a large capital-gains distribution in a year in which the fund lost money. In other words, you can lose money in a fund and still have to pay taxes. In 2000, for example, many technology funds made big capital-gains distributions, even though almost all of them were in the red for the year. Although the funds lost money during the year, they sold some stocks bought at lower prices and had to pay out capital-gains as a result. Technology-fund investors lost money to both the market and Uncle Sam that year.

The same thing happened to some funds in 2008. If a fund sold stocks that year (particularly earlier in the year before the market freefall) that had been purchased at lower prices, and could not offset those gains with any realized losses, then investors would have been on the hook for fund capital gains taxes in 2008--one of the worst years for the market in recent history.

Avoiding Overtaxation

Alleviate tax headaches by following these tips:

Tip One. 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.) Find out if the fund has tax-loss carryforwards, that is, if it has booked capital losses in previous years that can be used to offset capital gains in future years. That means the fund could be tax-friendly in the future.

Tip Two. 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.

Tip Three. 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. A fund with a turnover rate of 50% isn't four times more tax-efficient than a fund with a 200% turnover rate. But funds with turnover ratios below 10% tend to be tax-efficient. You can find turnover rates on Morningstar.com, as well as in your fund's annual report.

Tip Four. Favor funds run by managers who have their own wealth invested in their funds, such as Dodge & Cox Stock DODGX and American Funds Growth Fund of America AGTHX. 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. Morningstar tracks and reports on this data in our mutual fund Stewardship Grades, available on Morningstar.com.

Tip Five. 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.

Tip Six. 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.

Even following these tips, it can be difficult to find a fund that's consistently tax-efficient. But don't get so caught up in tax considerations that you overlook good performance. After all, a tax-efficient fund that returns 7% after taxes is no match for a tax-inefficient fund that nets 15% after Uncle Sam takes his share. (You can find after-tax returns in our Fund Reports on Morningstar.com.) In the end, it is what you keep, not what you give away, that counts.

Quiz 104
There is only one correct answer to each question.

1 Who controls how much funds distribute in taxable gains and income each year?
a. You, the fund shareholder.
b. The fund manager.
c. The fund company.
2 How can fund shareholders avoid taxes on their mutual fund distributions?
a. Keep their funds in tax-deferred accounts.
b. Reinvest their distributions.
c. Buy funds that have lost money this year.
3 Which type of fund is likely to be the most tax-friendly?
a. A fund that owns high-yielding bonds and has a 50% turnover rate.
b. A fund that owns stocks and has a 50% turnover rate.
c. A fund that owns stocks and has a 10% turnover rate.
4 When is the worst time to buy a fund, from a tax standpoint?
a. Right before a fund makes a distribution.
b. Right after a fund makes a distribution.
c. Any time is a bad time.
5 Which would you rather own in a taxable account?
a. A fund that gives away 5% of its pretax return to taxes.
b. A fund that gives away 15% of its pretax return to taxes.
c. Can't say; it depends which is the better aftertax performer.
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