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Beat The Tax Man And Maximize Your Fund Returns

By Werner Renberg

"My husband and I have always invested our money in tax-deferred accounts," a reader said. "We've never had any extra money to invest.

"We recently inherited $50,000 and would like to know what's the best thing to do with it to avoid capital gains tax.

"Somebody told me it's best to use an index fund because they don't pay capital gains distributions.

"Somebody else told me, 'Don't put money into mutual funds -- go into stocks and you won't have to pay capital gains tax until you sell them.'

"What should we do?"

First, recast the investment objective.

By expressing it as avoiding capital gains tax, the couple's focus may be diverted from their presumed real goal: earning a satisfactory long-run total return. Stating the goal only as maximizing total return -- usually understood to mean gross total return -- may give inadequate attention, however, to the tax costs usually associated with investments outside tax-deferred accounts.

A more appropriate goal would be to invest to maximize net (or after-tax) total return -- and to do so in a way that is compatible with their risk tolerance. That means, for one thing, adding the $50,000 to balances in tax-deferred accounts and figuring out whether all of the new money should be exposed to the stock market or whether prudent asset allocation suggests that part of it should be in a bond fund -- perhaps a federally tax-exempt municipal bond fund.

As for new equity investments, it is, of course, correct that putting money into individual stocks with the hope of capital appreciation -- and being lucky enough to have them go up in price -- would not involve paying income tax on any gains until they are realized when the stocks are sold in the future.

This contrasts with the potential tax consequences of mutual fund ownership outside a tax-deferred environment. Equity fund managers, too, invest in stocks in the expectation that their prices will rise. When investment considerations (or the need to meet redemptions) influence them to sell, they may realize both capital gains and losses and must annually distribute their net gains, if any, to their shareholders.

The shareholders then must pay income tax on those capital gains distributions. The tax on short-term capital gains, imposed at a taxpayer's ordinary income tax rate, can significantly eat into a fund's rate of return. The rate on long-term capital gains, now capped at 20 percent, can have an impact, too.

Which is, no doubt, why the reader wants to avoid both.

Does the comparison of stock ownership with fund ownership indicate that the couple should go for individual stocks?

Not at all.

When investing in individual stocks, prudence calls for trying to reduce investment risk by assembling a diversified portfolio of at least six or eight stocks. This would necessitate knowing which stocks to buy, as well as whether and when to sell any that appear to be losers. For advice, handling of transactions, and help in portfolio management, you would need a broker or other professional, who would be paid a commission or fee.

When you buy an equity mutual fund, you get not only instant diversification among a couple dozen or more stocks but also active professional management -- unless, of course, you buy a fund that's passively run to match the performance of a stock price index, as one friend suggested. You can let somebody else worry about whether the XYZ Company's latest quarterly earnings may fall a penny a share short of analysts' estimates.

A $50,000 stake would allow you to be diversified among a half dozen funds with different investment objectives, such as large-, mid-sized, and/or small-company stocks; a blend of the three; growth and value; foreign and domestic. You would not have to pay anyone a commission if you only chose no-load funds, and you should be able to enhance your return by limiting yourself to funds with low annual expenses.

I would first look at funds that apparently have not been suggested to the reader: tax-managed (or tax-efficient) funds, whose managers strive to hold down, if not avoid, taxable distributions. Among their techniques: keeping stocks for 12 months until they are eligible for the lower long-term capital gains rate, matching sales of stocks in which there are gains with those in which there are losses, selling highest-cost shares first.

This is a growing category, as an increasing number of fund companies are offering an increased variety of funds. Vanguard, for example, offers five to individual investors (four of which are matched by funds for institutions).

Next I would, indeed, look at equity index funds, whose variety has also been growing. They may not avoid capital gains distributions altogether, but they should have low portfolio turnover which should hold down their level.

If you also want to consider other actively managed funds, check the records of their past short- and long-term capital gains distributions to get a sense of the likelihood and level of future taxable distributions. Some funds may provide hypothetical after-tax returns for past periods in addition to pre-tax returns, giving you an indication of how much of their performance has been sapped by taxes.

Copyright © 2000 Werner Renberg. Reprinted with permission.