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The Impact of New Tax Laws on Mutual Funds

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June 20, 2003 — The new tax laws passed by the Federal Government may have a significant impact on mutual funds, so it’s important for investors to pay particular attention to the details, and how they can affect funds.

Under the new rules, shareholders will get to keep more of their portfolio’s capital gains and dividend income: The long-term capital gains rate will decrease to 15% from 20%, and dividends will be taxed at 15% from the maximum rate of 38.6%. Equity-income funds, high-yielding stock funds, and utility funds could be the major beneficiaries of the modified tax laws.

“As long as nothing else changes, investors will likely move more into stocks, specifically dividend-paying stocks, as a result of these tax law changes, and reduce their exposure to bonds,” notes Louis Harvey, president of Dalbar Inc., a Boston-based mutual fund consulting firm. “More people will invest in these stocks, which will then drive more companies to either increase dividends, or establish a new dividend-paying policy,” he adds. “We also think we will see more mutual fund firms creating more dividend-oriented products.”

Under the old rules, stock dividends were taxed as ordinary income. For mutual fund investors, those in equity funds are likely to be happier with the new tax laws than their bond fund counterparts, since interest payment from bond funds and money-market funds will still be taxed at the higher ordinary income rate. Among stock portfolios, index funds will be a primary beneficiary of the new capital gains tax rates given their low turnover rates. Taxes on short-term capital gains under the new plan are not being changed, and will remain at the investor’s ordinary income tax rate.

David Wyss, chief economist at Standard & Poor’s, points out that “index funds don’t have much short-term capital gains, which will be subject to higher tax rates. Tax-managed equity funds, which also feature low turnover, will benefit from the new laws too.” Indeed, index funds and tax-managed funds generate less in short-term capital gains with their buy-and-hold approach than most actively managed portfolios. According to Standard & Poor’s data, the two open-ended domestic equity index funds (excluding enhanced index funds*) with the highest yields as of May 30 are Institutional Select Large Cap Value Index (ISLVX) at 2.31%, and Institutional Select S&P 500 (ISLCX) at 2.26%.

As a result of the decreased dividend tax on many dividend-paying stocks, Wyss recommends that investors shift their taxable equity funds towards those with higher-dividend stocks, and reduce their fixed-income exposure, but not move entirely to equities.

In terms of equity sectors, Harvey contends that utility stocks and utility funds, which tend to pay high dividends, will become “far more attractive” to investors as a result of the new tax rates since “they provide stable prices and a high dividend yield.” However, some of the highest yielding investment products, real estate investment trusts (REITs), will not be subject to the new lower tax taxes. “REITs and REIT funds will now have strong competition for capital and competitors,” notes Harvey. “REITs will lose their edge as other stocks will provide high dividends and high yields.”

The table below lists the top five domestic equity funds with the highest dividend yields as of May 30. REIT funds, strategic allocation funds, “fund of funds,” and portfolios which can invest in REITs or fixed-income securities are excluded. Three of the top five are utilities funds, according to Standard & Poor’s data.


Gabelli Utilities/AAA (GABUX) 10.941.0

Berwyn Fund (BERWX) 7.532.0

Franklin Custodian Fds:Utilities Series/Adv (FRUAX) 5.130.6

Huntington Fds:Dividend Capture Fund/Trust (HDCTX) 4.488.0

Principal Utilities/A (PUTLX) 3.879.4

*Enhanced index funds typically invest in options, which would not receive any benefits from lower tax rates. Moreover, enhanced index funds also usually carry higher turnover rates than regular index portfolios, another reason they would not gain much from the new tax laws.