Mutual Funds
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The 10 best funds for the new tax law
The best funds to own will be those that yield high dividends and those with low turnover. Just be sure to put the right funds in the right accounts.
By Timothy Middleton
In the usual Washington trade-off, Democrats and Republicans mangled the Bush tax cuts, strangling economic reform in its cradle, but at least granting temporary taxpayer relief.
For every $50,000 in capital gains you harvest over the next five-plus years, Uncle Sam will seize $2,500 less in vigorish than he did under Clinton. For every $50,000 in dividends you receive, the tax savings will range from $5,000 to $10,000.
Taxes matter, especially for mutual fund investors. When the annual Morningstar Investment Conference kicks off later this week in Chicago, it will devote two full sessions to the new wrinkles in the tax code.
Rival fund-analysis firm Lipper is no less anxious to beat the tax drum, having just published research showing what a huge bite taxes take out of shareholder profits. Over the last 10 years, fund investors have lost 1.5 to 1.8 percentage points annually due to taxes, says Tom Roseen, a Lipper research analyst. Thats about 25% of total returns that they are losing each year.
Even if you invest strictly in a tax-deferred account, like a 401(k) or an IRA, you can take advantage of the new tax rules to pocket additional cash. And if the changes stick -- they expire in 5 years -- youll pocket even more as corporations spend less time dodging the taxman and more time making money.
And if the changes dont stick, youve still got half a decade to reap substantial tax savings if youre giving, or plan to give, appreciated securities to your children.
The numbers: Who saves what
The tax cuts trim marginal income-tax rates slightly. For investors, however, the cuts are more substantial.
The rate for long-term capital gains and dividends falls to 15%. Thats a cut of 25% from the former cap-gains rate of 20%. The cut on dividends, which formerly were taxed as ordinary income, is even greater. For someone in the 28% tax bracket, the reduction is almost half.
Taxpayers in the lowest brackets, 10% and 15%, get an even bigger break, with a new tax rate of 5% on dividends and capital gains. In 2008, moreover, that rate drops to zero.
Average tax savings, in the $2,500 to $10,000 range, which are calculated by T. Rowe Price, are based on the 25% and higher brackets. The new rates are already in effect: The dividend rule began on Jan. 1, followed by the cap-gains rule on May 6.
Not all funds benefit equally
Figuring taxes the new way will be easier for fund investors than for others. Fund companies will keep track of and report them, both to you and the IRS.
Although all mutual funds will benefit from the changes, some will benefit more than others. Funds that yield high dividends, like the equity-income group, are favored by the new rules over those that invest in stocks that dont pay dividends.
| Top equity-income funds | | Fund | 5-yr return | 12-month yield | | Parnassus Income Equity Income (PRBLX) | 9.91% | 1.7% | | American Century Equity Income (TWEIX) | 8.2 | 2.3 | | FAM Equity-Income (FAMEX) | 6.6 | 0.8 | | Van Kampen Equity & Income A (ACEIX) | 5.0 | 2.3 | | American Funds Capital Income Bldr A (CAIBX) | 4.2 | 4.6 |
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Note: Data as of 5/31/03.
Source: Morningstar
Also favored will be those with low turnover, meaning that when stocks are sold the gains on them will be long rather than short term. Short-term gains continue to be taxed as ordinary income. Many so-called tax-advantaged or tax-managed funds have low turnover.
| Top tax-managed funds | | Fund | 5-yr return | Turnover ratio | | Bridgeway Ultra-Small Company Tax Advantaged (BRSIX) | 12.5% | 56% | | Muhlenkamp (MUHLX) | 5.9 | 11 | | C&B Tax Managed Value Portfolio (CBTAX) | 5.4 | 9 | | Third Avenue Value (TAVFX) | 5.2 | 19 | | T. Rowe Price Tax-Efficient Balanced (PRTEX) | 4.2 | 24 |
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Note: Annualized returns as of 5/31/03.
Source: Morningstar
Contrariwise, funds that will be put at the greatest disadvantage by the new rules are those with high turnover. According to Morningstar, a large number of ProFunds and Rydex portfolios have annual turnover rates of 1,000% or more.
The right funds in the right accounts
If you dont have a taxable brokerage or mutual-fund account, the new rules encourage you to open one. The Achilles heel of tax-deferred investing is that all of your profits are taxed as ordinary income. If you retire in the 25% bracket, youll pay Uncle Sam a quarter on every dollar you take out, even if it represents a capital gain.
But if you own growth stocks in a taxable account and fixed-income securities in a 401(k), your retirement kitty grows by an additional 7.4% over 20 years, T. Rowe Price calculates, because the 15% tax hit on capital gains is so much less than the 25% rate for income.
Before you fire off an angry e-mail, let me stress Im not suggesting you drop out of your 401(k) plan. The advantages of tax-deferral are too great to ignore, and most of us will retire in lower tax brackets than those were in now.
But every dollar -- such as one that doesnt qualify for a company match -- that you can afford to invest in a conventional account can work harder than a brother buck in the plan, if its invested in tax-efficient growth funds.
Meanwhile, you can exploit the new rules to give money to your children. Kids 14 and older typically fall into the lowest tax brackets; the maximum for a single taxpayer in the 15% bracket is income of $28,400.
So between now and 2008, you can give them up to $11,000 a year in appreciated securities, with the appreciation taxed at only 5%. (Married couples can give $22,000 to each child each year.) In 2008, moreover, there's no tax at all.
Tax cut wont spur corporate reform
President Bushs main argument in favor of the cut on dividend taxes was an issue of public policy. They're taxed twice, at the corporate and taxpayer level. Interest payments aren't taxed at the corporate level. So corporations have an incentive to acquire debt rather than issue capital stock. This has produced a highly leveraged corporate economy.
It has also wasted uncounted billions of dollars as companies have retained and invested earnings that should have been distributed to shareholders.
When companies retain most of their earnings, they wind up reinvesting them in an array of dumb ideas and earnings growth slows down, says Robert Arnott, the editor of the Financial Analysts Journal who published research on the subject in January.
Nearly every company has a core that theyre pretty good at, says Ron Muhlenkamp, manager of his namesake fund. Where they get in trouble is when they have more money than they can profitably put in the core business, and they pour it down a rat hole someplace.
Unfortunately, Congress eviscerated the dividend scheme by condemning it to expire, along with all of Bushs other tax changes, in 2009. Until uncertainty is vanquished, balance-sheet reform will languish.
But meanwhile you can pick up a few dollars at the margin by paying attention to the taxes you pay. Unlike taxes on gasoline and phone calls and power-company bills (which can be as high or higher than investment taxes), they're not buried in the fine print. You can account for them easily, which means you can manage them easily, too.
What they're buying now
Chewing on dividends: Don Peters, manager of T. Rowe Price Tax-Efficient Growth Fund (PTEGX), cites William Wrigley Jr. (WWY, news, msgs), as an example of an excellent company that pays a decent dividend. It will probably grow in double digits over the next five years, he says. The dividend goes up smartly every year.
A cheap ride: John Montgomery manages all of the Bridgeway funds, which are driven by computer models rather than stock picking. In Bridgeway Aggressive Investor 2 (BRAIX), he notes hes gotten gains of nearly 50% in the last three months from Ford Motor (F, news, msgs). Id say its gone from really cheap to just cheap, he says. Even at todays higher prices, the dividend yield is still 6%.
At the time of publication, Timothy Middleton didnt own any securities mentioned in this article.
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