A Loaded Question

How can I best swap my costly Class B shares for less expensive, more tax-efficient funds?

Question: Three years ago, I went to a certified financial planner with $250,000 of my late husband's life insurance to invest. He sold me B shares of five funds and A shares of one fund, and I would withdraw a certain amount of money each month to supplement our Social Security. Now that I understand a lot more about loads and fees, these B shares are unacceptable to me. I'm ready to slowly sell off these funds and choose my own no-load funds.

My question is about taxes. These funds are in taxable accounts, and I'm having trouble finding information about funds and how to tell if they will be tax efficient.

Answer: Unfortunately, taxes may not be your most pressing problem when it comes to your investments. The way you set up your portfolio three years ago isn't ideal for your situation, either in terms of cost control or tax efficiency.

The first obstacle is the loads. As you've already discovered, every time you dip into your B shares for your monthly supplement, you're hit with a back-end load. You usually shouldn't put money into B shares if you know you're going to turn around and take it right out, says Bob FitzSimmons, a Lincoln, Neb.-based certified financial planner specializing in mutual funds. And since you need to pull money out every month, unfortunately, there isn't much you can do to minimize the tax hit. While we normally encourage our readers to stick with no-loads, scrapping everything you've got and starting from scratch may not necessarily be the best idea for you. That said, there are still some ways to salvage your current situation.

First, let's take a look at how the different share categories on load funds work. The B shares you bought have no sales charge in the beginning, but try to get out and you're hit with a back-end sales charge, usually around 4% or 5%. On the other hand, you paid an upfront fee, or a front-end load, for the Class A shares you bought.

While it might be satisfying to just clean house and get rid of all those B shares, you're still going to be paying that pesky back-end load. And even if you hold on to the B shares and dip into them on a monthly basis, you'll just be staggering that charge out. But the good news is that these loads gradually decline and ultimately disappear after six or seven years. So by staggering out your B-share redemptions over a number of years, you could save money in sales charges.

The best thing to do if possible is to stick with liquidating the A shares first since there's no penalty for selling them. Then you can minimize the penalties associated with the B shares by selling them at a later time when the sales charges decline. The only time that this wouldn't be advisable is if the A shares have declined precipitously in comparison to the B shares. Ideally, you'd want to select a fund to sell with the best performance. While this may sound counterintuitive, it will help you keep your portfolio's allocation in check.

Another option you could explore is to take out bigger chunks on an annual basis instead of smaller monthly withdrawals. For example, on the next anniversary date when presumably the back-end loads will decrease on those B shares, you could take out a year's worth of income from your funds and transfer it to a money-market account, advises FitzSimmons. Not only would this help you minimize your costs, but also simplify your tax bill.

While tax efficiency is important, there's very little you can do about your situation besides comparing the funds you already own to see which is the least tax-efficient and dipping into that fund first. A new Securities and Exchange Commission rule requires mutual-fund companies to disclose this information in all fund prospectuses beginning in February 2002. But some fund companies, like Fidelity and Vanguard, already have this information available on their Web sites. With U.S. equity funds down almost 12% for the year, chances are the tax hit will be minimal when April 15 rolls around. But if you're looking for more funds to fill out your portfolio's allocation in the future, a tax-managed fund would definitely ease the pain during capital-gains distribution season.