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Washington is probably not going to give financial advisors much help this year with fighting capital gains taxes on clients mutual funds.

Rep. Jim Saxton, R-Cherry Hill, N.J., the chairman of the House Joint Economic Committee, recently called the current treatment of fund capital gains distributions “discrimination” in a press release that tried to explain the issue to the general public.

“Mutual fund investors are subject to tax on capital gains distributions even if their mutual fund shares fall in value,” Saxton says in the release.

Saxton has introduced H.R. 168, a bill that would allow individual taxpayers to exclude as much as $3,000 in mutual fund capital gains distributions from taxable income, and circulated a second proposal that would exclude $5,000 in gains from taxable income.

So far, though, because of the federal budget problems and the new emphasis on national security issues, the environment for the two proposals is so challenging that “neither one has had a hearing,” according to John Collins, a spokesman for the Investment Company Institute, Washington. “Neither is even scheduled for a hearing.”

The U.S. Securities and Exchange Commission has tried to give investors some relief.

An SEC regulation that took effect Feb. 15 requires fund companies to publish after-tax return figures in the risk/return section of each fund prospectus, according to the text of the final notice.

But advisors will have to continue to rely heavily on traditional strategies for helping clients cope with taxes on mutual fund distributions, experts interviewed say.

Two Different Objectives

Fund managers get complaints about big capital gains distributions and other fund distributions because they serve two types of accounts.

One type consists of retirement accounts, college savings accounts and other tax-deferred and tax-exempt accounts. Owners of these accounts hold about two-thirds of U.S. fund assets.

The other type of account, the taxable mutual fund account, holds about one-third of U.S. fund assets, ICI says.

The tax rules are complicated, but the owner of a taxable mutual fund account could pay a maximum tax rate of 20% on 2001 “long-term capital gains distributions,” or gains paid as the result of the fund selling securities, according to Internal Revenue Service Publication 564: Mutual Fund Distributions.

“Most mutual fund managers treat tax-deferred and non-tax-deferred accounts as if they have the same investment objective,” says William E. Donoghue, chairman of W.E. Donoghue & Company Inc., Natick, Mass. “Thats absolutely absurd.”

Owners of tax-exempt and tax-deferred mutual fund accounts rarely worry about taxes on fund distributions.

The typical holder of a tax-deferred fund probably wished fund managers had sold far more stocks and generated far bigger capital gains in 2000, Donoghue says.

But paying income taxes on fund distributions irritates owners even when returns are strong, and it infuriates owners in years when fund assets actually lose value, according to reports by Eaton Vance Corp., Boston, a fund company.

Many retail investors ended up paying big capital gains taxes on money-losing funds in 2000.

Fund managers bought stocks in the mid-1990s, when prices were low, then held the stocks as prices soared. Because the prices were higher, the funds carried large amounts of “unrealized capital gains” or “embedded capital gains.”

Many consumers put money in the funds in late 1999 and early 2000, when stock prices and fund net asset values were sky-high.

Then, the market plunged. Managers sold their most expensive stocks to raise cash and guard against more drops in prices.

The fund managers recorded big gains, because the sales prices were far higher than the original prices paid for the stocks in the mid-1990s.

Managers passed the gains on to all investors, including new investors who reinvested all distributions, in the form of capital gains distributions.

But NAVs at many funds were lower at the end of 2000 than they are at the beginning.

The result: new investors ended up with a combination of lower account values and big, taxable capital gains distributions.

Fund companies paid out a record $325 billion in capital gains distributions in 2000, up from $238 billion in 1999, according to ICI.

In 2001, “the mutual funds didnt have these gains because theyve distributed most of them out,” says Norman Tamkin, a tax partner in the accounting firm of Holthouse Carlin & Van Trigt L.L.P., Los Angeles.

Capital gains distributions for 2001 fell to $72 billion, the lowest level since 1995, according to ICI.

The capital gains problem could return later this year if the stock market continues to rally, but fund managers might buy some time by using embedded losses on poorly performing stocks to offset gains on more successful stocks, Tamkin says.

A wave of articles that appeared in early 2001 described employees who exercised stock options from their employers shortly before share prices collapsed. Because of a provision called the alternative minimum tax, some of those employees ended up with a few thousand dollars in their investment accounts and obligations to pay hundreds of thousands of dollars in AMT taxes.

Taxes on fund distributions are usually not that devastating, but they can cause serious financial headaches, Tamkin says.

Although officials at the Internal Revenue Service will arrange installment payment plans, Tamkin had a hard time thinking of an example of the IRS voluntarily forgiving income taxes on mutual fund capital gains distributions simply because a taxpayer was unaware of the relevant tax laws. “The IRS wants to get paid,” Tamkin says.

The idea of taxing small, “buy and hold” investors who have lost fund asset value but are still plowing distributions back into a fund seems especially unfair, Tamkin says.

Because the buy-and-hold investors never see any cash, “its kind of phantom income,” Tamkin says.

How To Help

Advisors can help some fund investors minimize capital gains taxes by attending to basic financial planning concerns, such as persuading investors to buy variable life insurance and contribute to tax-exempt retirement accounts, such as Roth Individual Retirement Accounts, Donoghue says.

But “a lot of people cant put enough money in their retirement plan,” Donoghue says.

This year, in spite of the many changes in the Economic Growth and Tax Relief Reconciliation Act of 2001, the limit on IRA contributions is still only $3,000 for individual taxpayers.

EGTRRA increased the maximum 401(k) plan contribution to $11,000, and $12,000 for workers over age 50. But many employers impose lower limits, and socking large sums of cash away in a badly designed 401(k) plan is probably a bad idea, Donoghue argues.

Many consumers will want to consider taxable mutual funds or comparable vehicles once they have about $5,000 in investable, taxable cash, Donoghue says.

Investors who prefer ordinary, open-ended mutual funds can look for “tax efficient” funds.

The new SEC disclosure rule should help investors shop for funds with strong after-tax returns.

Morningstar Inc., Chicago, also suggests using a funds “portfolio turnover rate,” or the percentage of holdings sold each year, as a rough indicator of its tax efficiency relative to other funds in its class. All other factors being equal, a lower rate is better than a higher rate, Morningstar says.

A Morningstar fund screener shows, for example, that 83 of 426 U.S. stock mutual funds with more than $1 billion assets are reporting annual turnover rates of less than 20%. Two of those funds have one-year returns greater than 10%.

Investors who worry about sudden increases in turnover rates and investors who want to trade and short mutual funds as if they were stocks can invest in exchange-traded funds.

An investment company creates an ETF by depositing a block of securities, such as stocks picked to mimic the S&P 500 stock index, with the fund. The investment company then sells stock backed by the fund securities to the public and lists the fund stock on an exchange, ICI says.

The investment company can trade its own ETF shares for the underlying securities, but retail investors can only buy and sell shares on the exchange, ICI says.

ETFs do pass on ordinary stock dividends, and an ETF will realize some capital gains. An S&P 500 index ETF, for example, might sell stock when a company leaves the S&P 500, according to the Nasdaq Stock Market Inc., New York.

But ETF rules limit the ability of panicked retail investors to increase turnover rates by asking for their money back, and the capital gains distributions and dividend payouts tend to be relatively small, experts say.

Sophisticated investors with steady nerves and a large amount of taxable assets could consider “separately managed accounts,” or “separate accounts.”

A “separate account” is what used to be known as a “large, diversified securities portfolio.”

The investor buys a bundle of stocks designed to mimic the behavior of a stock index, or a mutual fund. The investor can limit capital gains distributions by deciding when to buy or sell the individual stocks.

Traditionally, investors have needed at least $100,000 to set up the equivalent of a miniature, personalized mutual fund. Today, advisors at companies such as BridgePortfolio.com Inc., Chicago, say they can use technology and packaged investment strategies to lower the minimum to as little as $10,000.

Guardian Life Insurance Company, New York, and John Hancock Financial Services Inc., Boston, are two examples of large, well-known financial services companies that market separate accounts to affluent customers.


Reproduced from National Underwriter Life & Health/Financial Services Edition, March 18, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.


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