03/01/2000

Tax Efficient Mutual Funds

Over the last several months, I have been writing about estate planning issues. Given that we are in the midst of income tax season, I thought I should forego discussing estate issues, and focus on the more timely subject of reducing income taxes. In this article, I will discuss tax efficient mutual funds. Yes, some mutual funds, either by design or by management style, generate less "realized" gains in a tax year and, therefore, are less burdensome when it comes to income taxes. The old adage goes " it’s not what you make that counts, it’s what you keep." In other words, the less you pay in income taxes on your gains, the greater the actual after tax return you keep. Tax efficient mutual funds focus on your after tax return.

As a mutual fund owner there are essentially two ways in which you can earn money:

1) Income -- as either dividends or interest

2) Capital gain -- the increase in the value of the price per share of stocks held in the funds portfolio. If the fund manager sells a stock in the funds portfolio that has increased in value, that is a realized gain. You, as a shareholder, pay taxes on the realized gain, even if you have not withdrawn money from your mutual fund account. If a stocks share price has increased in value, but the fund manager chooses to hold and not sell the stock that is an unrealized gain. The value of your account has increased, but you do not have to pay taxes on the unrealized gain (unless you take money out of your account).

At the end of a tax year, mutual funds are required by law to pass on all realized gains to shareholders. Thus, if you own a mutual funds and taxes are a concern, you want to have tax efficient funds -- funds that do not generate a great deal of realized gains to shareholders.

Several fund companies, have tax managed mutual funds. They are expressly designed with the goal of reducing the tax impact to the shareholders. Often they have the words tax managed or tax smart in their names. These funds fall into a range of investment objectives like all mutual funds -- growth, international, sector funds. Thus, in theory, you get the growth you are looking for, without the end of the year tax bill you are not looking for. How do the fund managers keep realized gains to an absolute minimum. Essentially, they do this in three main ways.

First, they attempt to balance "winners" and "losers." The winners are the stocks that have increased in value that the fund manager has chosen to sell, against the losers , the stocks that have lost value in a given year. For example, say Super Tax Managed Growth Fund manager decides to sell numerous shares of Microsoft that have increased in value. In doing so, the manager creates a realized gain of $2,000,000. Therefore, he/she would try to sell a loser, perhaps shares of Sara Lee that have lost about $2,000,000 in value. Thus, there would be no net realized gains to shareholders, and no end of year tax consequences.

Second, fund managers try to buy shares of stock and hold on -- not sell. In holding on to company shares and not selling them, they avoid realized gains to shareholders.

Third, tax managed funds generally are not fully invested in the market. They hold a certain amount of cash reserves so that they have the flexibility of not selling shares to fulfill redemption orders.

Several fund companies have tax managed funds and more companies are opening funds in this category every year. If you like mutual funds, but would like the tax deferred advantages of individual stocks, you should explore this category of funds.

Most mutual funds are not "tax managed" funds. However, some funds are more tax efficient than others. Naturally, mutual funds that employ some of the above methods tend to be more tax efficient.

One measure that is often correlated with tax efficiency is a funds turnover ratio. This is the frequency in which the fund manager sells the portfolio during a calendar year. A turnover ratio of 100% means that the fund manager has sold every holding he/she had at the beginning of the year --- the manager turned over 100% of the portfolio. Often, a mutual fund with a high turnover ratio is a fund that has high realized gains and is not very tax efficient. Naturally, turnover can mean selling losers as well as winners and therefore a high turnover ratio is not totally synonymous with high realized gains. However, if you are looking for a generally tax efficient fund, it would be wise to know the turnover ratio before purchasing as a possible indicator of tax efficiency. A very low turnover ratio is often a fund that is tax efficient. A funds turnover ratio can be found in most analytical summaries or by asking your financial advisor.

Some funds are naturally going to have reasonably high turnover ratios. For example, a fund trading in more volatile companies --say small or micro caps, would often necessitate a fund manager having to buy, then sell positions as company prospects change more frequently. This would lead to a higher turnover ratio and, perhaps, more realized gains on average. Other funds simply have a low turnover ratio because the style of the fund manager is to buy stocks and hold, not sell. To the contrary, other fund managers are "traders" moving frequently in and out of positions which generates high realized gains to the shareholder.

If you like a fund manager and /or a fund that has great returns but is not very tax efficient, try to use that fund in a tax shelter or retirement account. The tax efficiency of a mutual fund does not matter if the fund is held within an IRA, Roth IRA, 401k, SEP, variable annuity, etc. These are all tax shelters and all tax consequences (realized gains) are deferred until you withdraw money from the account. The Roth is a tax free vehicle in which withdrawals not taxed after age 591/2. Try to use your more tax efficient or tax managed funds in "open" accounts or non-retirement accounts and use the ones with poor tax efficiency but great returns in your retirement plans.

Tax efficiency is one consideration when purchasing mutual funds. If you have reasonably large capital gains derived from mutual funds in open accounts each year, then you might want to consider exploring funds that would offer more tax efficiency and/or purchase some "tax managed" funds. However, do not let taxes lead all of your fund decisions. First, find funds that meet your investment objectives that have good track records, low fees, etc., then, if taxes are a concern, evaluate the merits of their tax efficiency. In other words, do not let tax evaluation drive your investment decisions, but be aware of how you might have more tax efficiency and therefore, keep more of your great gains.

Please send questions or comments to dcoffin46333@wradvisors.com.