Taxing matters.

How to shield your returns from Uncle Sam

If you're a mutual fund investor, you don't have to concern yourself with which stocks to buy or sell--the fund manager, of course, takes care of that for you. But one thing most fund managers don't handle is your tax tab. In fact, many investors forget about this aspect of investing, but the IRS doesn't. Taxes can clip nearly 2% annually from the average fund investor's return.

"If you are working with an investment professional, that person should help you understand the tax consequences of your investment choices and especially subsequent actions that are taken," says Marilyn Broussard, a certified financial planner and senior financial advisor with Waddell & Reed, a St. Paul, Minnesota-based financial services firm.

Mutual funds are required by law to distribute all of their realized capital gains and dividend income to shareholders each year. Dividend distributions must be reported as dividend income on your tax return.

Mutual funds also distribute long-term capital gains resulting from the profitable sale of stocks. These distributions are reported as long-term capital gains on your tax return regardless of how long you've owned the mutual fund. Most mutual funds allow shareholders to automatically reinvest distributions instead of receiving cash. But you must pay tax on reinvested amounts just as if you received them in cash.

That's why when you buy shares of mutual funds, it can affect your tax liability. For example, if you purchase shares on December 1 and the fund distributes its 2000 capital gains and dividends on December 15, the payment is fully taxable even though you've only owned shares of the fund for 15 days. "If you plan to purchase shares in a mutual fund before year's end," says Dennis Filangeri, a Metaire, Louisiana-based certified financial planner, "pay close attention to the share price, because it may be higher than average immediately before the dividend distribution date."

He adds: "That investors need to be aware of the expected date and amount of capital gains distributions, because the price of shares will drop to reflect that distribution. Keep in mind that you must use caution around the end of the year. Weigh the potential return of your fund selection against any potential tax consequences."

In fact, some investors have leveled charges against the mutual fund industry claiming that it has ignored the tax consequences of such sales and treats all investors as if they are in such tax-deferred vehicles as IRAs or 401(k) plans. Some fund companies, however, are taking notice, and now offer tax-managed funds that are specifically designed to limit tax liability.

Tax-managed funds employ a number of techniques to achieve this objective. For instance, they keep portfolio turnover--the rate at which the fund manager buys and sells assets--low, because selling appreciated stock generates taxable gains. Also, these funds buy growth stocks that pay little or no dividends, since dividends are taxed as regular income. Among the funds with the best returns are Third Avenue Value (TAVSX) and the Standish Small Cap Tax-Sensitive (SDCEX). Of course, not all tax-managed funds are stellar performers, so experts advise investors to exercise caution in making their selections.

Evaluate the quality of these vehicles as you would traditional mutual funds: the fund's track record; the stocks in its portfolio; and the experience and investment style of the manager. "Tax efficiency is important, but investment performance should always be No. 1 for taxable investment accounts," says Edward D. Fullbright, a CPA based in Durham, North Carolina.

TOP 5 TAX-MANAGED FUNDS

                             Year-to-date     1-Year      3-Year
Fund Name (Ticker)              Total         Total       Total
                              Return(*)       Return      Return

Third Avenue Value              13.60          21.54      12.54
 (TAVSX)
Standish Small Cap              13.31          82.27      40.81
 Tax-Sensitive
 (SOCEX)
Muhlenka mp                     12.89           8.30      13.98
 (MVHLX)
Exeter Tax Managed              10.45          22.62      15.88
 (EXTAX)
Enton Vance Tax-Managed          9.16          19.17       N/A
 Emerging Growth
 (ETMGX)

                                                         Minimum
                             5-Year      Toll-Free       Initial
Fund Name (Ticker)           Total         Number       Investment
                             Return

Third Avenue Value            17.37     800-443-1021      $1,000
 (TAVSX)
Standish Small Cap             N/A      800-729-0060     100,000
 Tax-Sensitive
 (SOCEX)
Muhlenka mp                   20.70     800-860-3863       1,500
 (MVHLX)
Exeter Tax Managed             N/A      800-406-3863       2,000
 (EXTAX)
Enton Vance Tax-Managed        N/A      800-225-6266       1,000
 Emerging Growth
 (ETMGX)

(*) Ranked by cumulative total return as of 6/30/00

Source: Morningstar Inc.

BOTTOM 5 TAX-MANAGED FUNDS

                              Year-to-date     1-Year      3-Year
Fund Name (Ticker)               Total         Total       Total
                               Return(*)       Return      Return

Delaware Tax-Efficient            3.21          9.27        N/A
 Equity
 (DVXAX)
Golden Oak Tax-Managed           -3.47          1.99        N/A
 Equity
 (N/A)
Paine Webber Tax-Managed         -5.30         -5.72        N/A
 Equity
 (PWTMX)
Federated Large Cap              -6.70         27.54        N/A
 Growth
 (FLCAX)
DFA Tax-Managed U.S.             -6.01        -15.93        N/A
 Marketwide Value
 (DTMMX)(**)

                              5-Year      Toll-Free       Minimum
Fund Name (Ticker)            Total         Number        Initial
                              Return                     Investment

Delaware Tax-Efficient         N/A       800-523-4640      1,000
 Equity
 (DVXAX)
Golden Oak Tax-Managed         N/A       800-545-6331      1,000
 Equity
 (N/A)
Paine Webber Tax-Managed       N/A       800-647-1568      1,000
 Equity
 (PWTMX)
Federated Large Cap            N/A       800-341-7400      1,500
 Growth
 (FLCAX)
DFA Tax-Managed U.S.           N/A       310-395-8005          0
 Marketwide Value
 (DTMMX)(**)

(*) Ranked by cumulative total return as of 6/30/00. (**) Fund not available to individual investors. Account must be opened through an advisor.

Source: Morningstar Inc.