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| Tax-savvy strategies for mutual fund investors | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
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As always, the time to plan for next years taxes is now. Everything from which fund you pick to how long you hold it can help you manage your portfolio for maximum tax efficiency. By Timothy Middleton Any time of year is an excellent time to start thinking about next years tax day, because you cant undo in April any tax mistakes you made the prior year. The key for taxes is to be thinking the next year; its not to be thinking the last year, says David Diesslin, chief executive of his eponymous financial planning firm in Fort Worth, Texas. Taxes arent a major burden for mutual fund investors, but they need to be managed. Heres a particularly dramatic example from 2001: If you had invested $100,000 in Vanguard Tax-Managed Capital Appreciation Fund (VMCAX) five years prior to 2001, your total return of $207,870 would have been trimmed to $205,814 by taxes. If you had invested the same money in Galaxy II Utility Index Fund (IUTLX), which had an identical 15.76% annualized return over the same period, taxes would have scalped your total to $180,604 a difference of $25,210, or one-quarter of your original investment. We have found that on a typical $1 million account, we may be able to save a client as much as $50,000 a year by using a tax-efficient fund rather than its non-tax-sensitive equivalent, says Glenn Kautt, president of Monitor Group, a financial planning firm in Fairfax, Va. Thats because the average fund shareholder surrenders 5% of his annual returns to taxes -- more than three times the average fund expense ratio of 1.5%.
Tax-managed funds are only one tactic you can use to reduce the tax bite on your portfolio. A variety of strategies beckon. You can buy municipal bonds instead of Treasuries. You can own income securities in your retirement fund and growth equities in your taxable account. And especially if youve got long-term gains youre eager to realize, you can use losses to reduce or possibly eliminate them. Find tax-aware funds Investors have begun paying far more attention to taxes in recent years, and the industry has responded with portfolios that minimize them. Here are a few with outstanding tax efficiency.
Note: Ratings assume federal income tax rate of 39.6%. As of 2/28/01 Source: Morningstar Inc. The Vanguard Tax-Managed Capital Appreciation Fund is a classic tax-aware portfolio. It follows four basic strategies. First, it is indexed to the Russell 1000, so turnover is very low. Second, it uses highest-in, first-out accounting. Whenever shares have to be sold, the most expensive ones go first. Third, it actively searches for ways to realize capital losses as well as gains. The losses offset the gains for tax purposes. This fund started in 1994, and it has never paid out even one penny of capital gains, notes Brian Mattes, Vanguards spokesman. Fourth, it imposes what Mattes calls limitations of shareholder-induced turnover. If you buy it, plan to hold it at least five years; there is a 2% redemption fee the first year, a 1% for four years after that. Frequent trading is the antithesis of tax efficiency, Mattes notes. This kind of active tax management pays off. Here are four funds with identical total returns for the five years ended Feb. 28, 2001 After taxes, however, Vanguard shareholders ended up with more money in their pockets.
Note: Ratings assume federal income tax rate of 39.6%. As of 2/28/01 Source: Morningstar Inc. Hold 5 years -- unless the loss helps Infrequent traders can also benefit from a tax change that takes effect this year, lowering the rate on securities held five or more years by two percentage points. If youre in the 15% federal bracket, the rate goes to 8% from 10% and takes effect this year. If youre in a higher bracket, the rate goes to 18% from 20%, but you must hold the fund (or stock or bond for that matter) for five or more years. The catch is that for shareholders in higher brackets, you only get the benefit on securities purchased after Dec. 31, 2000, and held five years, says Sam Beardsley, a CPA in the investment tax group of T. Rowe Price Associates. In general, tax rules are the same for mutual funds and individual securities, but fund investors can skirt the 30-day wash-sale rule more easily than stock investors -- and the current bear market has piled up vast losses to be reaped in this manner. If any of your tech holdings are under water, you can sell them and book the loss for next years tax return. The wash-sale rule prohibits you from buying the identical security within 30 days, but fund investors can simply choose to buy a similar fund. When I raised this point in MSN Moneys Start Investing community, one member argued he didnt want to bail out of his favorite funds just for a tax benefit. I can see that, but Diesslin says its still worth looking into. With something like 14,000 funds out there, its hard to argue that you cant find a similar fund, he says. Put income funds in tax-deferred accounts All of these rules are immaterial in a tax-deferred account, such as a 401(k) or IRA. Nevertheless, you can use your retirement account to increase the tax efficiency of your overall portfolio. The trick, says Kautt of Monitor Group, is to own income securities in the retirement account and growth funds in your taxable account. The income will be taxed when moneys are withdrawn from the 401(k) at the same rate as they would be currently -- the rate for ordinary income. But gains in the growth funds will be taxed at the lower capital-gains rate. You end up keeping more of your money, Kautt says. Taxes should never be the sole consideration in investing; they are, after all, what Diesslin calls the dark side of a positive problem. You dont go broke making a profit. But theyre worth paying attention to. Tax savings over an investment career can be considerable. At the time of original publication, Timothy Middleton owned none of the mutual funds mentioned in this article. | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
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