Jury Still Out on Benefits of Tax-Managed Mutual Funds

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Are you getting a taxable capital gain from your mutual fund for 1999, even though the fund paid a disappointing return?

Maybe you’re thinking of switching to a tax-managed fund that promises to hold your taxes down. But most tax-management strategies don’t amount to as much as you think. This is especially true if you’re in the 28 percent tax bracket or less, or hold the fund for just a few years.

None of this matters for the funds that you own in retirement accounts. There, all gains are tax-deferred.

In non-retirement accounts, however, you’re taxed on your share of two things: the income the fund earns (dividends and interest) and the fund’s realized net capital gains. (A fund realizes gains by selling stocks that have gone up in price.)

Money managers who tax-manage their funds try to minimize your net capital gains. Here are the strategies they use only one of which appears to be truly effective.

– Salvage losses. A fund can subtract a capital loss from a capital gain. That eliminates the tax on the gain.

But any mutual-fund manager will sell the stocks that he or she thinks are losers. So what do tax-managed funds do differently? Chiefly, they sell stocks they really like but whose price is currently down.

Selling potentially good stocks may not be the best strategy from an investment point of view. “If your fund does a great job of salvaging losses, it might earn an extra one- or two-tenths of a percent per year,” says financial planner Harold Evensky of Coral Gables, Fla. “So there’s not a lot in it.”

– Keep turnover low. “Turnover” is the percentage of your fund’s portfolio that the manager sells every year, to replace with something else. In theory, the less your manager trades, the lower the taxable gains.

But research has shown that, for most funds, the turnover rate doesn’t make much difference to the tax you pay.

The average fund turns over nearly 100 percent a year. To get tax savings, turnover has to drop to around 15 percent or less, Evensky says.

Some index funds and tax-managed funds fall below that line. Others don’t.

– Buy stocks that pay little or no dividends say, growth stocks instead of utilities. But this isn’t special to tax-managed funds. It’s an investment decision that many managers make.

– Limit the taxes paid when a stock is sold. Here’s the pay dirt the only strategy that saves a significant amount of taxes, Evensky says.

Within any holding of a particular stock, some of the shares were bought at lower prices and others at higher prices. A tax-aware manager first sells the shares bought at a higher price. That minimizes the taxable gain.

On average, this strategy nets investors in the middle tax brackets an extra 0.6 percent year, Evensky says (and 0.8 percent in the highest bracket).

But any big, diversified fund can and should be managed this way, whether it advertises itself as tax-managed or not. A growing number of funds are paying attention to taxes when they sell, to keep their returns competitive.

Some critics say that tax-managed funds are storing up big trouble for themselves. Over time, they pile up unrealized gains. If the fund has to sell appreciated shares to meet redemptions, the remaining investors could owe a big tax.

In the worst case, that could happen. But why do fund investors sell? Usually, because the market falls. If shares had to be sold, tax-managers could sell the losers, meaning no tax.

According to Morningstar in Chicago, a mutual fund information firm, the 42 tax-managed funds it tracks netted 98 percent of their gains for investors, after tax. That’s over the past three years.

By comparison, investors in the average U.S. diversified fund netted only 85 percent of the funds’ gains.

But that assumes that investors’ income is taxed in the highest bracket (39.9 percent for ordinary income and short-term gains). The difference is much smaller for people in the 28 percent bracket, and negligible in the 15 percent bracket.

The returns for the tax-managed funds may also be biased, because they generally own big-company stocks. Those are the very funds that have done the best in recent years.

Tax-management might work for top-bracket investors who hold their funds 10 years or more. Otherwise, the case hasn’t been proved.

Syndicated columnist Jane Bryant Quinn can be reached in care of the Washington Post Writers Group, 1150 15th St., Washington D.C. 20071-9200.

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