Avoiding the Taxing Side of Mutual Funds

I buy stocks because I have always felt that there is no way to predict mutual-fund taxes. Am I too concerned with this issue?

QUESTION: I have bought only stocks so I could control what my taxes were going to be each year. I have always felt that with mutual funds there is no way to predict the taxes. Am I too concerned with this issue?




That said, your tax phobia may have a downside. For starters, it prevents you from enjoying the benefits of mutual funds, such as greater diversification and lower potential volatility. Additionally, a stock-only portfolio probably demands plenty of your time -- as well as your emotions. So you need to consider whether greater tax control is worth the added hassle and risk, says Don Cassidy, senior research analyst at fund-tracking firm Lipper.

But perhaps more important, your fears may also be somewhat excessive. Sure, there are a lot of tax blow-ups in the fund industry every year. But in recognition that there are many investors out there like you who might shy away from mutual funds out of tax terror, the fund industry also now offers a fairly wide array of tax-friendly investments.

First off, there are the "tax managed" or "tax aware" funds. These funds, which are rapidly growing in number (there are now 65, up from three in 1990), state tax efficiency as an objective in their prospectuses. Granted, they don't guarantee they'll never generate an ugly tax bill, but they are obliged to consider the tax consequences of their investment decisions.

Index funds are also known tax fighters thanks to their infrequent trading. However, this tax efficiency can decline with small-cap and midcap index funds, as their holdings tend to grow larger and move out of the indexes. When that happens, the index funds have to sell them, generating capital gains. If that's an area of interest for you, then you might want to consider exchange-traded funds, or ETFs, which are essentially index funds that trade like stocks. ETFs can be a better indexing route for the tax-conscious, since fund companies and the brokerage firms that represent ETF investors trade stock in-kind, so redemptions don't generate stock sales and capital gains. (Traditional mutual funds, on the other hand, take on gains when they're forced to sell stocks due to redemptions.) Investors seeking ETFs to give them exposure to smaller-cap indexes may want to check out the iShares S&P SmallCap 600 Index fund (IJR) or the iShares S&P MidCap 400 Index fund (IJH).

In a similar vein, you may want to investigate one of the numerous "stock basket" or "create-your-own-fund" products available now from Foliofn, Netfolio and Fidelity. E*Trade is also expected to roll out a similar product, with help from Standard & Poor's. These products allow you to have direct ownership of a group of stocks, but without the formal structure of a mutual fund or the huge transaction costs associated with purchasing them separately. Plus, since these are simply a group of stocks, rather than a fund, you can control the tax liability, since you choose when to sell shares.

Of course, as you probably know, one of the easiest ways to ensure tax efficiency is to invest via a retirement account, such as 401(k) plan or an IRA. You'll be taxed only once you begin withdrawing assets after reaching retirement, when you'll probably be in a lower tax bracket. You'll also reap the benefits of allowing your account to grow tax-deferred or even tax-free (with a Roth IRA).

And starting next year, you'll have a much easier time judging the tax burden of all funds, notes Bob FitzSimmons, a Lincoln, Neb.-based certified financial planner. Thanks to a Securities and Exchange Commission regulation that becomes effective in February 2002, all fund companies will begin publishing after-tax returns for one-, three- and five-year periods in their prospectuses. Granted, just as past returns are no guarantee of future performance, a fund's historical tax efficiency doesn't ensure the same in the future. But it can certainly be an important piece of information to consider when choosing a fund or deciding to stick with it.

Bottom line? It's always wise to keep eye on the tax efficiency of your holdings. But don't let the tax tail wag the investing dog.