How much did your clients give up to taxes on their reinvested mutual fund distributions for 2006? If they were not invested in tax-deferred retirement accounts, chances are it was a lot more than they are used to. A study from Lipper released April 17 says that buy-and-hold shareholders paid $23.8 billion in taxes on a record high $418.5 billion in distributions; that’s a big bite out of total returns.

“We’ve had a marvelous four-year period,” that came after the market shakeout from 2000 to 2002 in which funds accrued losses, says Lipper’s Tom Roseen, senior research analyst, U.S., and the author of the study, Taxes in the Mutual Fund Industry–2007. “There’s a law that says mutual fund companies must pass through virtually all their capital gains and income distributions in any given year,” Roseen points out, but losses can be carried forward. “We have had a tax holiday of sorts over the last several years. People were able to get the benefit of those tax loss carry-forwards as mutual funds passed through [a lower] amount of gains–not that they didn’t have the gains–but they offset those gains.” Now, though, those tax loss carry-forwards that were used to offset gains have “dried up,” Roseen explains.

Even though the amount of distributions, $418.5 billion, was a record, and the amount that went to taxes, $23.8 billion, was up 56% from 2005, according to the study, that’s still lower than the record for taxes paid on distributions in 2000, Lipper estimates, because of tax law changes in 2001 and 2003, which lowered the highest marginal tax rates from 38% to 25% and the rate for dividend distributions on equities, and long-term capital gains, to 15%, Roseen points out. That helped dividend-paying equity funds, and those with long-term capital gains especially, but left income distributions on taxable bond funds to be taxed less favorably, at marginal rates of up to 35%. It’s a drag on returns.

These distributions are not from individuals trading their mutual funds–”these are from investors doing nothing more than buying and holding their funds,” Roseen notes, “and that’s what’s the most appalling about it.”

Rep. Jim Saxton (R-New Jersey) introduced a bill on January 10 to defer capital gains taxes on open-end mutual fund distributions that are automatically reinvested, according to Roseen. It is HR 397, and it has been referred to the House Ways and Means Committee. Currently, investors get a 1099 and have to pay taxes on fund distributions for each year they are paid out, even if investors have them automatically reinvested by the fund company.

Actively managed funds that are also tax managed have higher average long-term total returns than actively managed funds that are not tax-managed, according to Roseen. “Tax-managed funds outperform their actively managed brethren in over 50% of the years that we’ve reviewed. It’s above average; that’s not saying that they hit home runs every time,” Roseen says, but “if I can get above average returns, then I’m winning, and I’m beating them on total returns–and then I beat them on an after-tax basis? I’ve got the best of both worlds.”