Financial Planning for August 1999

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Mutual Fund Trading Pretax & After Tax
Mutual Funds are a good investment choice for after-tax returns but be sure that you get complete and accurate information before you make an investment decision. Many listings report "total return" assuming that all distributions of dividends and capital gains are reinvested and they make no adjustment for taxes.


Assume that John Smith has purchased $10,000 in AA mutual fund. He pays $10 per share and buys 1,000 shares. The fund sells for $15 at year-end and makes an income distribution of 30 cents per share and a capital gains distribution of $3 per share. The capital gains distribution reduces the share price from $15 to $12. John now reinvests all of these distributions ($3,300 on his 1,000 shares) in more shares of AA, now listing at $12. Thus, John buys 275 new shares, bringing his total up to 1,275 shares.
According to the official statistics, John's holdings are worth $15,300, a 53% return on his investment.

However, John will have to report $300 in dividend income and a $3,000 capital gain on his tax return. If you assume that there is a 40% state and federal tax rate on his dividends and a 24% tax rate on his capital gains, John will owe $840 in tax on those distributions whether or not he touches a penny. His total return for the year is a 44.6% gain rather than a 53% gain.

The Reality

The painful fact about mutual fund investments is that they are subject to large tax bites. Over a ten year period, a $10,000 investment that returned 14.5%, or $38,700, based on all distributions being reinvested, would only return about 11.84% per year or $30,700. In this case about $8,000 would be lost to federal taxes over ten years.

These are average fund returns. Obviously, some funds return a greater amount than others. After taxes, some funds that appear to be better, actually perform worse.

The Explanation

The discrepancies on mutual fund values are explained by the tax laws. The mutual funds must pass through to shareholders virtually all their ordinary income from dividends and interest in order to avoid the corporate income tax. Though not required, they may also distribute capital gains. Remember:

· Dividends and interest are taxed as ordinary income.
· Short-term capital gains on securities held one year or less also are taxed at ordinary rates.
· Long-term capital gains are taxed no more than 20% at the federal level.

The point to remember is that most managers trade without regard to the tax consequences for investors because they are generally rewarded for their pretax rather than their after tax return.

Trimming the Tax

There are ways that you can avoid paying those hefty taxes on mutual funds. Make a short list of the funds that you think will perform best pretax. Then you can favor the following types of funds because of their performance after tax.
· There are an increasing number of funds designed to trim investors' taxes. These tax-efficient funds offset gains with losses or they sell high-basis shares when reducing a position in a given company.
· Low-turnover funds do relatively little trading which means fewer gains to pass through to investors.
· Index funds are designed to track a particular market index such as the S&P 500. The makeup of the index stays fairly constant so they seldom realize taxable gains.

The best way to reduce taxes is to trade funds sparingly.


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