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The "Double-Whammy": Taxes Add Insult To Injury Of Paper Losses

By Werner Renberg

For 1999, Janus Venture Fund, a small-company growth fund which had been an uneven performer in the previous decade, had a total return of 140.7 percent -- far ahead of the 21 percent for the Standard & Poor's 500 Index and the more relevant Russell 2000 Index, a leading benchmark for small-company stocks.

Investors who held the shares in taxable accounts did not do quite as well after paying income tax on the fund's distributions of income dividends and short- and long-term capital gains, but, of course, they did very well nevertheless.

Distributions totaled $14.26 per share -- 40 percent accounted for by more highly taxed short-term capital gains -- and were equivalent to 25 percent of the fund's 1998 year-end net asset value (NAV) of $57.14.

Now, more than a half year after taxes on 1999 distributions were due, things look different:

• The fund's NAV, which had more than doubled in 1999 to $121.67, is down between 25 and 30 percent for the year to date.
• Janus estimates that the fund's net income and net capital gains from its sales of securities, both of which will lead to taxable distributions, amounted to about $20 through September, or about 16 percent of the end-of-1999 NAV. Final figures for 2000 won't be known for a few weeks.

Shareholders of Janus Venture are not alone in experiencing the "double-whammy:" a fund's having a negative return -- to date, at least -- while at the same time, apparently exposing them to taxable distributions that would enlarge the negative net return for the year.

Whether funds that you own could provide you with a similar experience, you should be able to determine, sooner or later, by contacting your fund companies and/or accessing their web sites. Although equity fund shares held in taxable accounts may account for only an estimated 25 percent of total equity fund assets, the companies are increasingly disseminating distribution estimates for investors' year-end planning -- subject, of course, to revisions that become necessary when final data are totaled.

If you own funds in taxable accounts -- in addition to, or instead of, IRAs and 401(k) plans, in which taxes are not payable on a current basis -- high rates of distributions need not be surprising:

• Taxable income distributions are expected from funds invested in taxable bonds and/or income-producing stocks.
• Funds that have histories of distributions -- especially more costly short-term capital gains distributions -- that are high in relation to their NAVs may be expected to continue the pattern.

You may, of course, occasionally find surprisingly high estimates of distributions, such as in cases of managerial changes when new managers overhaul the portfolios they inherited or in cases of investment policy changes that result in higher-than-usual portfolio turnover.

In the belief that many investors with taxable accounts do not fully appreciate the impact that income taxes on distributions can have on their net returns, the Securities and Exchange Commission offered for public comment a proposed rule that would require funds to disclose after-tax returns as well as the familiar pre-tax returns. Comments have been received, but the rule has not yet been finalized.

A bill directing the SEC to require such disclosure, introduced in 1999 by Rep. Paul E. Gillmor (R-OH), was passed by the House of Representatives last April, 358 to 2, but remained in the Senate Banking Committee as Congress approached adjournment.

You can get an idea of what such comparisons could be like from Vanguard's web site, which provides pretax and after-tax data as of Sep. 30, based on the assumption that shareholders are taxed at the maximum 39.6 percent rate for dividends and short-term capital gains, 20 percent for long-term capital gains.

For the year ended Sep. 30, such hypothetical after-tax returns would range from 99 percent of pretax returns for Vanguard's Tax-Managed Capital Appreciation and Small-Cap Growth Index Funds, 98 percent for Capital Opportunity, 97 percent for Tax-Managed Growth & Income, and 96 percent for 500 Index and Total Stock Market Index Funds to 58 percent for Windsor II and 65 percent for Equity-Income. (The after-tax estimates assume distributions are reduced by taxes owed on them before reinvestment.)

Comparable data calculated by Morningstar for Morningstar fund categories found the average large- and mid-sized company growth funds with average after-tax returns, as percentages of pretax returns, at 92 percent and 94 percent, respectively -- both above their average sibling value and blend funds. Small-company growth, value, and blend funds were clustered at 95 to 93 percent.

What can you do to hold down taxes you will owe for 2000 on your taxable mutual fund accounts?

• Unless you have a compelling reason to invest sooner, try to defer new purchases until after the record dates for distributions (which fund companies will tell you).
• If you have unrealized losses on funds, you may wish to sell shares to realize them -- investing the money in other, different but suitable funds, if you don't need it -- and use the losses to offset gains, thereby reducing taxes on those.
• If you have unrealized gains on funds that you wish to capture, determine whether you have losses on shares that you could realize and offset at least a portion of your gains.

What can you do for future years?

• Be mindful of potential tax consequences when making new fund investments, taking a look at the various tax-managed funds offered by several companies and studying the relevant return and distribution data made available by others.
• Ask your Senators and Representative in the next Congress to support legislation to permit you to defer income tax on certain capital gains distributions if you reinvest them. A bill to do this was introduced in June by Rep. Jim Saxton (R-NJ), vice chairman of the Joint Economic Committee. Although many investors wrote to support it, not enough did so to stimulate Congress into action. If re-elected, Saxton plans to re-introduce the bill in January.

Copyright © 2000 Werner Renberg. Reprinted with permission.

More articles by Werner Renberg can be found here.