From the October 2007 issue of Boomer Market Advisor • Subscribe!

October 1, 2007

Mutual fund taxes are on the rise

Russel Kinnel of Morningstar notes that mutual fund tax bills are on the rise for the fourth year running. Kinnel says the average capital gains distribution for U.S. equity funds rose to 4.17 percent of assets in 2006, compared with 3.32 percent in 2005 and 1.67 percent in 2004. The cause of those payouts is a good thing. It means funds have produced solid returns for a few years running. Although returns were pretty good in 2003 and 2004, the distributions were small because capital gains were offset by realized losses during the early-2000s bear market. However, most of those losses are long gone. Here are a few things Kinnel recommends to limit your client's tax bill.

  1. Max out on tax-sheltered accounts. Taxable distributions are not a problem for 401(k)s, 403(b)s, and IRAs, so invest as much as the law will allow before money is put in taxable accounts.
  2. Consider tax-managed funds for taxable accounts. Tax-managed funds such as those offered by Vanguard do a great job of avoiding making distributions because they realize losses on some holdings when they have to realize gains on others. After taxes are figured in, these funds generally put up superior returns.
  3. Consider exchange-traded funds. ETFs don't have all the strategies available to taxmanaged funds but they do have some unique features that help reduce their tax bill. Make sure to choose one that is diversified, has low costs and has low turnover.
  4. Don't buy funds that have had huge returns over the past three years. Buy a fund with huge gains and a huge tax bill will follow, regardless of whether the client made money. So, tread carefully in hot areas. If you have your heart set on such a fund, at least put it in an IRA or 401(k).
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