Aftertax mutual fund returns.

When clients ask for investment recommendations that will provide them with growth, many CPAs? turn to historical mutual fund data for the answer. A common--and perhaps misguided--practice is to begin the research by reviewing a fund's historic returns Most mutual fund information sources such as Morningstar or CDA Weisenberger list funds by type and performance. More often than not, however, they report returns on a pretax basis. While some CPAs may think taxes do not greatly affect fund performance, Morningstar says mutual fund assets paid out as taxable capital gains and dividends rose 35% last year.

Consider this example. An investor divides $200,000 equally between two funds, X and Y, on January 1, 1997. At the end of the year, both funds report a 25% annual return. Fund X declares and distributes to the investor yearend capital gains and dividends of $38,823 while fund Y distributes only $7,024. Because the investor elected to reinvest the dividends in both funds, he thus has the same amount in both accounts at yearend. The gains are taxed at 28%. (For assets held over 18 months, a 20% rate applies. For the taxability of assets held between 12 and 18 months, an investor must rely on information supplied by the fund.) As a result, returns are reduced in fund X by $10,870 and in fund Y by $1,967. The investor's aftertax rates of return are now only 14.16%, in fund X and 23.8% in fund Y, even though they were both the same--25%--on a pretax basis.

While researching this article, I came across a fund that reported a pretax gain of 18.01% in 1997. The fund distributed sufficient gains to shareholders to create a $4,358 loss after taxes were paid. That is, an investor who began the year with $100,000 in her account ended the year with a net investment of only, $95,642 after paying her taxes, despite the 18% return! Clearly, CPAs must make taxes a major consideration in helping clients select mutual funds. While a cardinal investment rule says an investor should never select an investment for tax reasons, a corollary to that rule says the tax consequences of an investment never should be ignored.

EVALUATING FUNDS FOR TAX CONSEQUENCES

A CPA should consider several factors when evaluating a mutual fund investment with an eye toward its tax consequences.

Turnover ratio. The turnover ratio is a measure of the fund's trading activity. It is computed by dividing the lesser of purchases or sales by the fund's average monthly assets. A ratio of 150% means the fund's portfolio has turned over 1 1/2 times while a 25% ratio suggests that only one-quarter of the holdings have been sold. Since some holdings may be sold, bought and sold again, a ratio of 100% does not necessarily mean every issue has been traded. The ratio is only an indication of how much trading the fund does; it suggests how much in capital gains the fund may be generating and, thus, what sort of tax consequences investors might face. Morningstar studies indicate that funds must have a very low turnover ratio (10% or less) to achieve a significant reduction in the amount of capital gains distributions.

Manager style. Mutual fund managers may be traders or long-term investors. Those who set price targets for stocks and sell only when those targets are reached may generate more gains than managers who buy and hold. CPAs can get insight into this area through research and by studying a particular manager over time. In particular, they should watch out for funds whose management has changed; the new manager may not like the portfolio he or she inherited and may decide to sell many of the fund's current holdings, creating the potential for gains.

FUND ALTERNATIVES

Certain types of mutual funds are managed in ways that minimize detrimental tax consequences for investors.

Tax-managed funds. By minimizing taxable transactions such as gain-generating sales and stocks that pay dividends, the 26 mutual funds Morningstar identified in this category had an average pretax return of 27.49% in 1997 and an aftertax return of 27.29%, a difference of only 0.20%. Overall, diversified domestic mutual funds gave up 3.16% of their return to taxes in 1997 while the S&P 500 index relinquished 1.06%. The 26 tax-managed funds averaged only a 23% turnover for 1997 compared with 84% for the typical domestic growth fund. Last year, 17 of the 26 tax-managed funds (65%) beat the 21% average aftertax return of growth funds. CPAs should, however, exercise caution in using such funds. A fund's performance over the long run could be impaired if its manager holds a stock he or she would prefer to sell because of shareholder pressure to avoid taxes. Tax-managed funds have only been around a short while, and it is not yet clear whether they are the answer to the high tax consequences of mutual funds.

Index funds. Another solution for an investor is to purchase index funds. These funds are essentially unmanaged and turn over only when an issue is removed from an index such as the S&P 500. Because index fund issues change infrequently, there is little turnover and thus few gains and little or no tax liability. Some financial planners argue that index funds represent a low tax, noncustodial alternative to an IRA because most tax liability is delayed until the investor sells his or her shares. Under most circumstances, the low tax liability of these funds makes them attractive, particularly as few fund managers equal or exceed the return of indexes over an extended period. For example, pie, the S&P 500 stock index fund of a large mutual fund company had a tax liability of only 0.33% in 1997, reducing its net return to 32.84%, which compares favorably to the 21% average aftertax return for domestic growth funds.

THE IMPORTANCE OF TAXES

It is critical that CPAs, when advising clients on mutual fund selection, give careful consideration to an investor's goals and objectives, particularly his or her income tax status. The investment program a CPA designs must be carefully integrated--first with the investor's risk tolerance, then with his or her financial objectives and, finally, with tax considerations. While taxes are the last concern, they can alter risk by decreasing net returns and thus increasing the probability of loss. Although it is wise not to put the cart before the horse, it's important not to forget to hitch the horse to the cart before you start out.

PATRICK R. CHITWOOD, CPA/PFS, PhD, is an investment adviser with Cahaba Private Advisory Group in Birmingham, Alabama. His e-mail address is [e-mail].