INVESTMENTS  -  TAX EFFICIENT
 

Investments/Tax-Efficient (1st)

Evaluate your Funds from a Tax Perspective

Each year at tax time, mutual fund investors face some unpleasant surprises, and this year was no exception. Soon after celebrating a year of across-the-board mutual fund gains, many investors realized that along with spectacular gains came spectacular taxes due on 1999 dividends and capital gains. The real investment returns (the tax-adjusted returns) offered by some of their favorite funds were not as big as they thought, and some top-performing fund returns dropped to below average on an after-tax basis.

Well, here is the bad news: Unless you invest in a tax-deferred retirement account or a muni fund, taxes can significantly erode your investment earnings. The good news is that tax efficiencies vary from one fund to another, and some planning today may let you breathe easier next April.

Taxes can greatly affect a fund’s tax-adjusted performance. Tax liabilities are rarely a concern of most fund managers, whose role is to obtain the highest total (before-tax) return, except when tax efficiency is among the fund’s objectives. Besides, it is difficult to accurately portray a fund’s after-tax performance, which depends on each shareholder’s federal and state tax bracket as well as the type of account the fund is put into, i.e., currently taxable or tax deferred. Therefore, it is up to you, the investor, to choose funds that are right for your tax situation. Yet most investors take little heed of this – to their financial detriment.

The following paragraphs take a brief look at some of the tax aspects of mutual funds and provide tax-management strategies aimed at minimizing your mutual fund tax bite.

Mutual Fund Distributions. The method and timing of mutual fund distributions are two of the more perplexing tax issues. Under current tax regulations, all funds are required to distribute at least 98% of their realized capital gains and dividends to shareholders annually. These distributions are taxable to non-retirement accounts regardless of whether you have them reinvested in the fund or receive them in cash. As long as you hold shares of the fund on the record date of the distribution, you must report these gains on your tax return.

There are basically two kinds of mutual fund distributions: ordinary dividend distributions and capital gains distributions. Ordinary dividends are the most common types of dividends and include not only dividends paid by corporations, but also interest on bonds and money market funds and net realized short-term capital gains the fund earned on sales of securities. (Calling interest and short-term capital gains “dividends” always have and always will be a source of great confusions to many mutual funds investors.) Whatever their source, these dividends are taxed as ordinary income, which could be as high as 39.6%. A fund’s capital gains distribution represents the net realized long-term capital gains generated by the fund. Some funds report unrealized long-term capital gains. If your fund does, you must report these gains on your tax return. These distributions are taxed at the long-term capital gains rate, which for most investors is 20%. Capital gains may also be incurred when you sell a fund, if the sales price is higher than the tax-cost basis (basically, the price you originally paid for the shares, adjusted for any distribution that is reinvested during the time you owned the fund). But since capital gains are being distributed every year you own the fund, and these distributions increase the tax-cost basis of your shares, any capital gains due upon the sale of a fund are likely to be small. One exception to this, discussed below, involves highly tax-efficient funds that are structured to minimize yearly capital gains distributions. If, when you sell the mutual fund shares, the sales prices is lower than the tax-cost basis, then you may realize a capital loss when the shares are sold.

Timing the purchase of a mutual fund can avoid unwanted taxes. The key here is to avoid buying a fund just before it makes a distribution. Otherwise, you could end up paying taxes on gains that occurred before you even owned the fund.

Tax Efficiency of Mutual Funds. The relative tax efficiency of a mutual fund depends largely upon the fund’s investment objectives and the way in which it is managed. At one extreme, all or virtually all of the income distributed by single-state municipal money market funds is not taxable. At the other end, funds striving for capital appreciation and/or high current interest income often distribute large capital gains and/or interest or dividends to shareholders. Between the two are endless varieties in terms of tax efficiencies.

Funds that invest in municipal securities are the most tax efficient due to the federal and, perhaps, state tax exemption of muni interest income. Much to the chagrin of some underinformed investors, however, income distributed by muni funds is not necessarily altogether tax-free. Any short- and long-term realized capital gains are subject to tax. Within the muni bond fund group, those total-return-oriented funds that strive for capital appreciation tend to incur higher taxable distributions, and those yield-oriented funds that hold securities for long terms tend to have lower tax liabilities.

With respect to stock funds, index funds, which employ a buy-and-hold strategy, are usually more tax efficient than actively managed funds. Research shows that actively managed funds need to achieve two to three percentage points higher pre-tax annual returns than stock index funds to offset the tax liabilities resulting from active trading.

The investment style of a fund may also affects its shareholders’ tax obligations. Lower turnover funds tend to have smaller capital-gain distributions than higher turnover funds. Growth funds usually have relatively lower dividend distributions, currently averaging less than 1%, compared with income funds whose dividend yield averages 3%.

But within most stock fund categories, there are some funds that are intentionally managed to minimize taxes. These funds go one step further than index funds in their efforts to minimize tax liabilities. They may employ a number of strategies, including deliberately selling losers to offset gains from other stocks, selling shares with the highest tax-cost basis when less than an entire position is sold, minimizing turnover, and avoiding high-yield stocks. Many mutual fund companies run a number of tax-managed funds that use one of more of these strategies.

Minimizing Your Tax Bill. Investors shouldn’t let the tax tail wag the dog. Other considerations, including past investment performance, risk, and how a particular fund complements other investment holdings, are usually more important. But tax consequences should receive at least some attention in mutual fund selection. After all, income taxes can easily consume one-third or more of your investment income. Anything that can be done to minimize that bite while still meeting your overall investment objectives merits your consideration.

Always investigate before you invest. Two funds with similar state performance figures may produce quite different after-tax returns. With respect to bond funds, all other things being equal, choose the one that offers you the higher after-tax return. Chances are, that will be a municipal bond fund. If the choice is between a corporate bond fund and a U.S. Treasury bond fund, the nod may well go to the U.S. Treasury fund if you reside in a state that assesses high taxes on interest income, because interest from U.S. Treasury securities is exempt from state income taxes.

Before buying a bond or stock fund, find out what percentage of its total returns has been paid out as dividends and capital gains in recent years. Funds with lower distributions tend to pay higher net after-tax returns to their shareholders.

Turnover rate is another consideration. In general, the higher a fund’s turnover rate, the larger its short-term capital gains distributions. Although two funds may have similar unrealized capital appreciation, the one with the lower turnover rate will probably take a longer time to distribute its gains. Mutual funds have an average turnover rate of 80%; but some have much lower rates, as low as 15%.

Another way to predict a fund’s future tax liabilities is to find out how much unrealized capital appreciation is already built into the fund portfolio. The unrealized capital appreciation is a rough indicator of the fund’s potential tax liability: In general, the higher the unrealized capital appreciation, the greater the future capital gains distributions will be. Morningstar and the Value Line Mutual Fund Survey provide data on unrealized capital appreciation as well as other measures that will help you assess the tax efficiency of a particular fund.

Finally, put those otherwise desirable funds that the most tax “unfriendly” in an individual retirement account, company-sponsored retirement plan, variable annuity, or other tax-deferred investment account, and let them accumulate without adverse tax consequences along the way.
 

Investments/Tax-Efficiency (2nd)

CASE STUDY: PUTTING TOGETHER A TAX-EFFICIENT MUTUAL FUND PORTFOLIO

Background. George Bassett is an investor whose job as chief operating officer at a large medical center places him in the 3% federal income-tax bracket. After the passage of the Taxpayer Relief Act of 1997, he became concerned that the new tax rules reward long-term stock investors with the 20% maximum capital gains tax rate, but penalize investors who take gains on investments held less than 18 months.

George has a substantial taxable portfolio - $200,000 invested 80% in stock funds and 20% in U.S. government bond funds. He was horrified to learn that most of his stock funds generate primarily short-term capital gains (for stocks held one year or less) taxed at his ordinary income-tax rate of 36%. The funds do generate some mid-term gains (for stocks held more than one year but not more than 18 months), which are taxed at 28%, but his funds produce few long-term gains (for stocks held more than 18 months) that qualify for the new 20% rate. In George’s opinion, “18 months isn’t a very long time to hold onto a stock, but judging from the capital-gains taxes I paid last year, my fund managers must think it’s an eternity.” What’s more, he’s paying  a 36% federal tax on the income from his government bond funds.

“It wasn’t so bad before the new tax rules came along. Most of my capital gains were taxed at 28%. But the new 20% rate means I can keep a lot more of my gains – but not with the current roster of funds I own. I could buy individual stocks, of course, and hold onto them for at least 18 months. But I don’t have time to ride herd on a bunch of stocks. I’ve always been more comfortable with funds, but I would like a more tax-friendly portfolio than I’ve now got.”

Analysis. It’s no secret that tax efficiency is not a big selling point for most mutual funds, since most fund managers make trading decisions regardless of the tax consequences to individual shareholders. Under the new tax rules, however, an increasing number of investors in all tax brackets are interested in taking advantage of the reduced capital-gains tax rate for their investments. So-called “tax-efficient” funds either have a history of minimizing, or are designed to minimize, heavily taxed capital-gains distributions.

What makes a fund “tax efficient?” A look at the annual turnover rate – the percentage of holdings a fund sells each year – is one quick measure. High turnover can mean that the fund distributes a high percentage of short-term gains taxed at investors’ ordinary-income tax rates. According to the American Association of Individual Investors, research indicates that turnover of 10% or less is needed for true tax efficiency. Yet the average mutual fund has a turnover rate of 80 to 90 percent. (In contrast, an index fund that sells stocks only when the composition of its index changes may have a turnover rate of about five percent.) Turnover doesn’t tell the whole story, though.

A low-turnover fund holding stocks that pay high dividends, such as a growth-and-income, equity-income, or balanced fund, may still be tax inefficient, because the dividends are taxed at ordinary-income rates. And a low-turnover fund that has accumulated substantial unrealized gains could create significant tax liabilities for investors, even at the lower capital-gains rate. (The fund manager might have to liquidate holdings and distribute the gains in order to meet massive redemptions by investors during a bear market, for example. Or a change in the fund’s investment objectives or manager could result in a similar sell-off, with similar results.) Such a fund could of course minimize the taxes passed on to investors through strategies such as accumulating loss carryforwards, just as a high-turnover fund could achieve tax efficiency through a strategy of offsetting capital gains with capital losses, or selling the shares with the highest cost basis first.

Investors leery of capital-gains exposure are often attracted to funds that have substantial inflows of new cash, especially new funds run by experienced managers. But it’s easy for a fund to disguise tax inefficiency, particularly in a bull market, by spreading distributions among an increasing number of investors – with unfortunate consequences if performance declines. One of the best ways to judge a fund’s tax efficiency is to compare its pre-tax returns with its tax-adjusted returns, information that can be calculated from data contained in the Value Line Mutual Fund Survey. As the following hypothetical example illustrates, tax efficiency has a significant impact on real return, and a tax-managed fund with less impressive pre-tax returns can offer more after-tax income than a “regular” mutual fund with higher pre-tax returns.
 
 

	Pre-tax	Tax-adjusted	Efficiency	Lost to Taxes
Growth fund	23.3%	23.2%	82%	18%
Tax-managed  growth fund	24.6%	23.9%	97%	3%

Investment strategy. George has decided not to limit his portfolio to the relatively small number of available funds that are specifically managed to minimize taxes, but also to select funds that meet his investment objectives while considering the following criteria as selection guidelines:

v A track record of above-average performance relative to a fund’s peer group.

v An expense ratio that is below average for a fund’s peer group.

v A manager who has performed well on a risk-adjusted basis, compared to asset-class peers, according to Value Line’s overall rank, and/or direct peers, according to Manager Rating.

v Low turnover rate, unless specific strategies are in place to minimize short- and mid-term capital gains.

v Readily available information that enables investors to identify and sell shares with the highest cost basis first (“highest in, first out”).

v A consistently high tax-efficiency rate.

Over the next two years, George wants to put together a moderately aggressive portfolio with a long-term horizon that will provide both growth and tax efficiency (see table below). It will include municipal bond funds because he has determined that these funds, historically, at least, have provided greater after-tax returns than the government bond funds he currently holds. But because he realizes that even a tax-managed fund cannot guarantee continuous tax efficiency, particularly in a bear market, he will not select funds solely on the basis of their current tax efficiency, but will focus on buying – and holding – above-average funds within each asset class.

George Bassett’s Tax-Efficient Portfolio
 
 

STOCK FUNDS %	ALLOCATION
Tax-efficient growth	25
Tax-managed growth and income index	20
Tax-efficient small company	15
Tax-managed international index	20
Subtotal	80
BOND FUNDS %
Single-state muncipal	10
Multi-state municipal	10
Subtotal	20
Total	100

Investments – Tax-Efficient (3rd)

Investment Case Study: Fine Tuning Portfolios to Minimize Income Taxes and Maximize Return

An ingredient essential to long-term investment success is putting each investment in the most tax advantageous account. For example, virtually all investors know that you shouldn’t put tax-free municipal bonds and municipal bond investments in retirement accounts because the retirement account itself is tax advantaged. In effect, were one to put a muni into a retirement account, what would have otherwise been tax-free interest income will end up being taxed, since all income earned by a retirement account is subject to income taxes when the money is withdrawn.

But beyond the obvious, there are a variety of ways to fine tune your investing which will help add value to your investments. In fact, tax-wise investing could well turn a fair long-term return into a very good one.

Background. Bill and Susan Benner have been investing for over 15 years in a variety of investment accounts, including a taxable brokerage/mutual fund account, some tax-deferred accounts, a 401(k) plan and two IRAs, and, finally, a custodial account for their 14-year-old daughter, Brenda. While the Benners have paid close attention to investment allocation, and devote considerable time to evaluating both new and currently held investments in all of their accounts, they have become concerned about the taxes that they currently pay on their investments, as well as the taxes they will eventually have to pay when they retire and begin drawing on their retirement accounts. “Susan and I have been quite pleased with our investment results over the years. Now that we have started to accumulate some substantial investments, we’re a bit concerned about the taxes we’re now paying on them.”

Susan adds, “Our CPA told us that we’re beginning to incur a hefty tax bill on our investment income, and he said we should pay some attention to that. Since we are both working, Bill and I are now in the 31% federal tax bracket, and six percent state taxes on top of that. So we think this is a good time to review our investments to see where we stand taxwise. Maybe we should have more money in municipal bonds and bond funds, but I’m not sure that’s the total answer.

Analysis. Table I shows how the Benners’ three investment portfolio categories, taxable, tax-deferred, and custodial, are currently invested. They are quite happy with the investment allocation of 60% stocks, 30% bonds, and 10% cash, and they would like to maintain it. Moreover, while they would be open to suggestions for changing the way their money is invested among the various categories of investment, e.g., stocks, stock funds, etc., for the present they would prefer to maintain the same total investment level in each category. For example, they would like to continue with $60,000 invested in individual stocks, although they welcome suggestions as to the most appropriate account or accounts to hold the individual stocks.

While Table I indicates a diversified total investment portfolio, from a tax standpoint, many of the Benners’ investments are not placed in the most tax-advantaged accounts. The following recommendations are based on the same general premise: The most-heavily taxed investments should be placed in the tax-deferred or lower-taxed investment accounts, while the less-heavily taxed investments should be placed in taxable accounts.

Recommendations. The following recommendations for fine tuning the Benners’ investment portfolio are reflected in Table II.
 

TABLE I

The Benners’ Current Portfolio
 
 

	Long-Term Taxable	Tax-Defereed	Custodial	Total $	Total %
Individual stocks	$10,000	$30,000	$20,000	$60,000
Stock Funds	50,000	50,000	20,000	120,000
Total Stocks	60,000	80,000	40,000	180,000	60%
Treasury bonds		20,000		20,000
Treasury bond funds		20,000		20,000
Municipal bonds	10,000			10,000
Municipal bond funds			10,000	10,000
Corporate bonds	10,000			10,000
Corporate bond funds	20,000	______	______	20,000
Total bonds	40,000	40,000	10,000	90,000	30%
Money market funds & CDs		30,000		30,000	10%
Total investments	$100,000	$150,000	$50,000	$300,000	100%

1. Individual stocks. Individual stocks enjoy a tax advantage that is not available through most stock mutual funds: the investor controls the timing of capital gain recognition because the investor can choose when to sell a stock. Thus, stocks can appreciate in value over time without incurring capital gains, so long as the investor holds onto the stock. Individual stock issues are therefore better situated in highly-taxed accounts. Thus, Table II shows that, rather than investing in stocks across all three account categories, the Benners should consider holding all individual stock investments in their taxable account.

2. Stock funds. As it now stands, the Benners’ stock funds are also spread across all three accounts. Stock funds are a heavily-taxed investment because investors cannot control the timing of capital gains recognition. Therefore, the recommended course of action is to discontinue investing in stock funds in the taxable account and instead hold all of the stock funds in the tax-deferred account and the low-tax custodial account. (Since Brenda is now age 14, her account is no longer subject to the “kiddie tax,” and will, therefore, incur taxes on income at her low tax rate.)

3. Treasury bonds and bond funds. At present, all of the Benners’ Treasury bond and bond fund investments are situated in their tax-deferred accounts. For residents of states that impose an income tax, Treasury investments are often better placed in a taxable account to take advantage of the exemption of Treasury bond interest from state taxes. In fact, Treasury interest earned in a tax-deferred retirement account will actually be subject to state income tax when the money is withdrawn from the retirement account. This may seem like a minor saving, but over the years, these savings can add up. Table II shows a suggested shift of most of the Benners’ Treasury investments from the tax-deferred accounts to the taxable accounts.

4. Municipal bonds and bond funds. The Benners’ municipal investments are not (see Table I) split between the taxable and custodial accounts. They should move their muni investments entirely to the taxable account because, as noted above, the custodial account will now be taxed at a lower tax rate than the parents’ taxable account. Municipal bond investments should be concentrated in the higher-tax accounts.

5. Corporate bonds and bond funds. Since corporate bond and bond funds are the most heavily taxed bond category, and consistent with the rule of putting highly-taxed investments in low-tax accounts, the Benners should consider moving the corporate bond and bond fund investment money from their taxable account to the tax-deferred account, as indicated in Table II.

6. Money market funds and CDs. Money market funds and CDs are now entirely contained in the tax-deferred accounts. The Benners may want to spread this money out into all three account categories. This will provide each account with some liquidity to take advantage of new investment opportunities. Moreover, keeping some cash in the taxable account will allow quick access to money should an unexpected need arise.

A final comment. In the process of fine-tuning their investments, the Benners should analyze the tax effects and transactions costs of any required sales and purchases. The costs involved may, in some instances, not be worth the tax savings. But by carefully determining the most tax-advantageous account in which to place an investment, investors can minimize income taxes, which in turn increases total investment return.

TABLE II

The Benners’ “Fine-Tuned” Portfolio
 
 

	Long-Term Taxable	Tax-Deferred	Custodial	Total $	Total %
Individual Stocks	$60,000			$60,000
Stock funds	______	100,000	20,000	120,000
Total stocks	60,000	100,000	20,000	180,000	60%
Treasury bonds	10,000		10,000	20,000
Treasury bond funds		10,000	10,000	20,000
Municipal bonds	10,000			10,000
Municipal bond funds	10,000			10,000
Corporate bonds		10,000		10,000
Corporate bond funds	______	20,000	______	20,000
Total bonds	30,000	40,000	20,000	90,000	30%
Money Market funds & CDs	10,000	10,000	10,000	30,000	10%
Total investments	$100,000	$150,000	$50,000	$300,000	100%