A taxing problem.
Each January millions of mutual fund investors open their 1099s to face the grim news of how much taxable income and gain they will have to report. But in the past five years no new type of fund has provided more good news for certain investors than tax-managed mutual funds.
When an investor holds mutual funds outside IRAs and other tax-deferred retirement accounts, the cost of maintaining such investments includes taxes as well as commissions and management fees. Many mutual fund shareholders find taxes on interest, dividends and realized gains are the largest cost they face. With most distributions reinvested in additional shares, investors have to dig deep into their pockets to pay the tax bill.
Each year, fund sponsors introduce hundreds of new mutual funds. (Today there are more than 10,000 funds in existence.) For tax conscious investors, tax-managed mutual funds are one solution to the problem of taxable mutual fund distributions. These funds seek to invest in a way that will minimize taxes and maximize long-term growth. With tax rates on net investment income and realized short-term gains as high as 39.6% and realized long-term gains taxed at a top rate of 20%, investing in a tax-managed fund can help an investor protect a substantial portion of his or her investment return.
Although there are fewer than 100 tax-managed mutual funds (see exhibit 1, for a sampling), their stated goal of reducing the impact of federal and state income taxes on fund returns gives clients who already contribute the maximum amount to tax-favored IRAs or 401 (k) plans another low-tax way to invest in the stock market.
Exhibit 1: A Sample of Tax-Managed Mutual Funds
American Century Tax-Managed www.americancentury.com Value Fund Dreyfus Premier Tax-Managed www.dreyfus.com Growth Fund Eaton Vance Tax-Managed www.eatonvance.com International Growth Fund Evergreen Tax Strategic Equity Fund www.evergreen-funds.com Fidelity Tax-Managed Stock Fund www.fidelity.com JP Morgan Tax-Aware U.S. Equity Fund www.jpmorgan.com/mutualfunds PaineWebber Tax-Managed Equity Fund www.painewebber.com State Street Research Legacy Fund www.ssrfunds.com T. Rowe Price Tax-Efficient www.troweprice.com Balanced Fund Vanguard Tax-Managed Growth Fund www.vanguard.com
As CPAs try to keep pace with the best investment vehicles to help clients realize their goals, tax-managed mutual funds are an increasingly important way clients can hold down taxes, leaving more for retirement, college funding and other key objectives. Here are some of the things CPAs will want to know about tax-managed mutual funds before recommending that clients add them to their portfolios.
Tax-managed mutual funds operate the way most other mutual funds do. The difference is in how the funds are managed: Most fund managers tend to sell stocks with the lowest cost basis--and the highest profit--to boost returns, but tax-managed fund managers follow a different strategy, emphasizing aftertax returns.
The aftertax return an investor earns from a mutual fund investment is a function of four factors:
* The investor's own tax circumstances (tax bracket, filing status).
* The pretax returns the fund earns.
* The fund's tax efficiency.
* The investor's time horizon.
Tax efficiency is determined by the makeup of the fund's returns. A typical equity fund has realized short-term gains and investment income that are taxed as ordinary income (maximum rate, 39.6%); realized long-term gains that are taxed at favorable capital gains rates (maximum rate, 20%); and unrealized capital gains that are not currently taxable. A tax-efficient fund has more long-term capital gains and less investment income and short-term gains.
To avoid having to pay taxes at the fund level, a mutual fund must distribute a minimum of 90% of its income (net of fund expenses) and realized capital gains to shareholders. An investor pays taxes on all distributions, whether he or she elects to take them in cash or reinvest them in additional shares. (For more on the taxation of mutual fund distributions, see "Mutual Fund Tax Trap".)
Taxes have a substantial negative effect on mutual fund returns. For example, if an equity fund returns 10% in a particular year, deriving 3% of that return from dividends and short-term gains, 5% from realized long-term gains and 2% from unrealized gains, its return shrinks to only 7.8% after federal taxes, as shown in exhibit 2. That means 22% of the fund's return has been lost to taxes--before even considering the impact of any state or local taxes. (In high tax states such as New York or California investors see their return shrink even more.) Although most mutual fund managers pay little attention to how taxes can cut into a fund's return, tax-managed fund managers must balance investment and tax considerations and evaluate how their trading will affect a typical shareholder's tax liability.
Exhibit 2: Impact of Taxes on Fund Returns
Pretax Tax Aftertax Returns Rate Returns Total return 10.0% 7.8% Dividends and short-term gains 3.0% 39.6% 1.8% Long-term gains 5.0% 20.0% 4.0% Unrealized gains 2.0% 0.0% 2.0%
Source: Eaton Vance, Boston.
A mutual fund's turnover rate--how frequently the fund manager buys and sells securities--has a substantial impact on an investor's aftertax return. Tax-managed funds generally have low turnover rates. Since most fund managers look to maximize pretax returns, they don't even consider the tax impact of their trading frequency. The result is that an investor's aftertax returns can be significantly lower than the fund's advertised pretax returns.
Lipper Analytical Services, Inc., says the annual portfolio turnover rate for the average equity fund is 86%; for the average growth fund, the rate is 81%. A high turnover rate means there is the potential for the fund to realize more taxable gains. According to Morningstar, Inc., the average diversified equity mutual fund gained 14.3% in 1998 and lost 12% of that return to taxes. In contrast, the average tax-managed fund gained 21.57% in the same period and lost only 1% to taxes.
Historically, mutual fund performance has been measured by pretax returns. But with approximately 60% of mutual funds in taxable accounts, this may not be the best way to judge true performance. With the tremendous stock market gains in the latter part of the 1990s and after several years of record mutual fund distributions, investors have become more conscious of aftertax returns.
Despite the option to follow tax-efficient strategics when investing in individual stocks and bonds on their own, many investors prefer the ease of mutual funds--professional management, greater diversification, improved liquidity. A tax-managed fund, with a low turnover rate, can significantly increase returns. As exhibit 3, illustrates, if a high-bracket investor holds a high-turnover stock fund for 30 years before selling it, a $25,000 investment might grow to $187,888. However, if the same investor uses a low-turnover fund, the same investment could grow to $335,930.
Exhibit 3: Tax-Managed vs. Non-Tax-Managed Funds
* $25,000 investment.
* 10% annual rate of return.
* 8% annual turnover in buy-and-hold account.
* 81% annual turnover in high-turnover account.
* Taxes are paid out of account each year, with remaining income invested in additional shares.
* After year three, annual distributions are assumed to be 50% ordinary income and 50% long-term gains.
* 20% long-term capital gain rate upon redemption
Even Congress is concerned that high pretax returns may be overstated and potentially misleading to investors. The House of Representatives is considering a bill to require fund sponsors to make improved disclosures. (See "Congress Chimes In," for more details.)
SEC chairman Arthur Levitt Jr. is also speaking out on the tax implications of mutual fund investing. Many investors "lack a clear understanding of the impact taxes have on their mutual fund returns," he says. In a February speech before the Mutual Fund Directors Education Council, Levitt cited the estimated $34 billion that stock and bond fund shareholders paid in taxes on fund distributions in 1997. On March 15 the SEC issued proposed rules requiring companies to disclose aftertax returns in fund prospectuses. Funds would not be required to include aftertax returns in advertising or other sales materials. The deadline for commenting on the proposed rules--available at www.sec.gov/rules/proposed/33-7809. htm--is June 30.
THE RIGHT STRATEGY
How does the manager of a tax-managed fund go about minimizing taxes? For example, here are some techniques Eaton Vance Tax-Managed Emerging Growth Fund says it uses to achieve tax-efficient management. The fund
* Invests primarily in lower-yielding growth stocks.
* Employs a long-term approach to investing.
* Tries to avoid net realized short-term gains.
* When appropriate, sells stock, trading below their tax cost (basis) to realize losses.
* When selling appreciated stock, it selects the most tax-favored share lots (those with the highest cost basis).
* Selectively uses tax-advantaged hedging techniques as an alternative to taxable sales.
Other funds employ similar strategies. State Street Research Legacy Fund uses what it calls a buy-and-hold approach to allow the fund to focus on long-term capital appreciation while reducing--although not eliminating--taxable capital gains distributions. The T. Rowe Price Tax-Efficient Balanced Fund adds tax-free municipal bonds to the mix. Its objective is to provide investors with "attractive" long-term returns on an aftertax basis with a balanced portfolio of stocks and municipal bonds. The fund invests a minimum of 50% of its total assets in tax-exempt securities.
Because large unexpected redemptions could disrupt this buy-and-hold strategy, some tax-managed funds impose a redemption penalty to discourage investors from making large withdrawals that might force management to sell securities to raise cash.
RISK AND RETURN
As with any investment strategy, tax-efficient investing carries risks as well as rewards. In evaluating tax-managed mutual funds for their clients, CPAs should use the same criteria they would use to judge any other fund, including
* The track record, background and experience of the fund manager.
* Internal fund expenses.
* Fund performance history.
* Risk relative to the fund's peer group.
* Style consistency. (Does the portfolio stick with its selected style?)
There are, however, some special risks associated with tax-managed funds that CPAs should consider:
* Tax-managed funds are relatively new, and many have little or no track record investors can use to judge performance, risk and other factors.
* Tax-managed buying and selling might conflict with the manager's style, reducing pretax returns.
* Over time, a tax-managed fund may accumulate a large portfolio of unrealized gains. Investors in such funds face the risk the fund will decide to realize some or all of these gains and pass them through to shareholders.
* Tax-managed funds frequently use various hedging strategies to protect gains instead of selling shares. These strategies leave the fund open to large potential losses.
* The fund's long-term investment strategy may require it to hold a security in a down market when stock prices are declining.
It's also important to remember that an investor who doesn't pay Uncle Sam now is likely to have to pay later. Many tax-managed funds achieve their returns through unrealized capital gains, which means the value of the fund's shares continues to grow. When an investor decides to sell his or her shares, the gain on disposal could be much higher than it might be with a mutual fund that had distributed its gains over time. Still, depending on the investor's holding period, the gain on sale is likely to be taxed at favorable long-term capital gain rates. Such a scenario also puts the investor in the driver's seat; he or she decides when to realize and pay taxes on capital gains, rather than the fund manager.
WHO ARE THEY GOOD FOR?
Tax-efficient investing isn't good, or even necessary, for everyone. Low-bracket taxpayers generally will do better investing in more conventional mutual funds, since taxes aren't a big concern. Tax-deferred retirement accounts also are likely to obtain higher returns from other kinds of funds since they don't pay taxes currently. There are, however, some clients a CPA will find particularly suited to tax-managed mutual funds, including
* Tax-conscious investors who already have contributed the maximum amount to IRAs, Keoghs or 401(k) plans, or those who aren't eligible to contribute.
* Investors seeking a flexible, more-liquid alternative to variable annuities.
* Irrevocable trusts looking for capital appreciation with minimal tax consequences.
* Those seeking funding vehicles for money transferred to children under the Uniform Transfer to Minors Act, where income earned by children under age 14 is generally taxable at the parents' tax bracket.
* Any investors who want less taxable income, such as an older client seeking to lower his or her investment income and thereby minimize the amount of Social Security benefits subject to tax.
TAX-MANAGED, NOT TAX-FREE
When recommending tax-managed mutual funds to clients, it's important that CPAs make sure clients understand that tax-managed does not mean tax-free. The funds seek to minimize taxes, not eliminate them. With the stock market still providing the potential for substantial gains, few investors can afford to overlook the fact that taxes reduce their mutual fund returns, and tax-managed funds provide one solution to a vexing problem. Some investors, however, still haven't gotten the message. A July 1999 Mutual Fund Magazine survey found that taxes aren't a concern for most mutual fund investors. In the poll, only one in eight investors put taxes near the top of a list of important considerations in judging a mutual fund's appeal. As a result, CPAs may find they have to save these clients from themselves by educating them about the impact taxes can have on mutual fund returns. If the growing number of tax-managed funds is any indication, more and more clients are getting the message every day.
In a 1999 report, Tax Managed Mutual Funds and the Taxable Investor, KPMG looked at the tax efficiency of mutual funds, the advantages of managing an equity mutual fund for aftertax returns and the impact tax efficiency can have on net aftertax returns. KPMG found that a long-term taxpaying investor can achieve higher aftertax investment returns from a tax-managed equity fund than from a conventional equity fund managed without regard to tax considerations--assuming the same level of pretax returns.
Copies of the study are available from Eaton Vance Distributors by calling 1-800-225-6265, ext. 8129 or e-mailing email@example.com.
Keeping More Money in Shareholder's Pockets
For Armin J. Lang, vice-president and portfolio manager of Eaton Vance s Tax-Managed International Growth Fund, tax-managed investing is a 24-hour-a-day job. Because the fund concentrates on overseas companies, Lang must work when the global markets are open. Sometimes, he says, it seems as though "my office is my home."
In Lang's mind, the essence of tax-managed investing is fairly simple: "You want to make sure the money ends up where it belongs--in the shareholder's pocket. From what I've seen recently, more and more mutual fund investors end up giving money at the end of the year to their least favorite charity, Uncle Sam" And that, Lang says, is something he tries to avoid by any means. "If you look at the capital gains distribution of our tax-managed equity fund, it is zero, was zero and will be zero. That means the shareholder gets to keep all of the money he or she deserves."
Lang says tax-managed investing in an international environment is much the same as it is domestically. "There's virtually no difference. It comes down to the same characteristics. You want to be a long-term investor, and that holds true for both U.S. and international equities."
When asked about the difficulties of tax-efficient investing, Lang says it helps to have a strong investment philosophy. "My philosophy is very much long-term. If I buy a stock today, I expect to hold it for at least five years, if not more. If you look at the average portfolio manager, international or domestic, I don't think there's anyone who has a five-year time horizon." The bottom line, Lang says, is "the difference between buying companies and trading stocks."
Lang is bullish on the long-term prospects for tax-managed investing. "Five years from now, I'm convinced no one will look exclusively at pretax returns. Everyone will look at aftertax returns, even in funds that aren't necessarily managed with that goal." Lang goes so far as to predict that fund sponsors will offer qualified and nonqualified mutual funds, with the latter managed to be more tax efficient. And he points out that the SEC is "on the case" following Chairman Arthur Levitt Jr.'s February comments promising stricter disclosure of aftertax returns.
In looking to the future, Lang offers this example: "When you receive your paycheck, you don't just look at the top line number, you look at the bottom line, your take-home pay. That's exactly what's going to happen with mutual funds. If you own a fund that returns 45% and you check the bottom line and see the aftertax return is also 45%, you're happy. If you have another fund that returns 15% and after paying taxes on capital gain distributions the bottom line is that the fund returns only 5%, you know you have a problem. This will lead investors to tax-managed funds."
Over the last five years, Lang says, investors have had the benefit of de cent stock market returns. He cites an investor in a domestic equity fund that returns 20%. "If you give up 250 basis points of that return to taxes, at least you'll still have 17.5% left." In the next five years, Lang says, market gains might be flat and investors won't be so lucky. "You may look at your 1099 and see the return on your fund was 0, but you still have to pay the tax man. That's when the idea of mutual funds that are managed for people who pay taxes will really take off."
Mutual Fund Tax Trap
When a mutual fund experiences net redemptions (shareholder redemption requests exceed new investments), the fund's remaining shareholders may fall victim to a potentially large "tax trap." The trap results from the tax treatment the Internal Revenue Code affords mutual funds and their shareholders.
IRC section 852(b)(3)A imposes a tax on the excess, if any, of a fund's net realized capital gains over the deduction for capital gains the fund distributes to shareholders. To avoid this tax at the fund level, it is normal industry practice for a fund to make a capital gain distribution that is substantially equal to its net realized capital gains. Mutual funds normally make one such distribution per year, usually around the end of the fund's fiscal year. Only shareholders who own the fund on the record date receive the distribution.
After several years of investment growth, many mutual funds have experienced substantial appreciation in the value of their portfolio. (CPAs can find information on a particular fund's unrealized gains in Morningstar.) As a fund approaches yearend, it must distribute all of the gains it was forced to realize to meet shareholder redemption requests. Although this distribution is taxable to the remaining shareholders, the redeeming shareholders recognize no tax consequences (other than any gain or loss on the sale of their shares). The redeeming shareholders not only force the fund to liquidate securities and realize substantial capital gains, but they shift the tax consequences of this gain to the remaining shareholders.
Most financial planners recommend that clients focus on long-term goals and ignore short-term market fluctuations. They typically advise against attempting to "time" the market. But as the above scenario illustrates, this may not always be the best advice from a tax perspective. When a client owns shares in a mutual fund that is experiencing substantial net redemptions and also has significant unrealized appreciation, the potential exists for a large tax liability. Financial planners may want to recommend the client liquidate his or her investment in such a fund before yearend to avoid capital gain distributions.
Tax-wise financial planners know to advise a client to avoid purchasing a mutual fund just before it is due to make a capital gain distribution. For clients considering investing in a fund that has experienced large net redemptions, that advice is even more astute. In fact, it might be prudent for a planner to anticipate the problem of potential capital gain distributions from new mutual fund purchases much earlier in the year, by keeping tabs on the fund's net redemptions.
--Phyllis Bernstein, CPA, director, AICPA personal financial planning division
Congress Chimes In
Congress is concerned that mutual fund performance figures don't give the true picture of the effect taxes have on investor returns. In March 1999, Representative Paul Gillmore (R-Ohio) introduced HR 1089, the Mutual Fund Tax Awareness Act of 1999.
The bill expresses concern that
* The average mutual fund investor loses up to 3% of a fund's return to taxes every year.
* Portfolio turnover has nearly tripled, to almost 90%, from 30% 20 years ago.
* Average capital gain distributions from growth funds have more than doubled in the last 10 years.
The bill's sponsors believe improved disclosure of tax efficiency by mutual fund companies would allow shareholders to compare aftertax returns to raw performance and help them determine if a fund manager tries to minimize shareholder tax consequences.
If passed, the legislation would require the SEC to revise regulations under the Investment Company Act of 1940 mandating improved disclosure methods in prospectuses and annual reports of the aftertax effects of portfolio turnover on mutual fund returns. Congress has held committee hearings on the bill, but no formal action has yet been taken.
* INCOME TAXES CAN EAT UP A SUBSTANTIAL PORTION of the investment return on an equity mutual fund. For tax conscious investors, tax-managed mutual funds offer a relatively recent solution to this problem. In 1998 the average tax-managed fund lost only 1% of its return to taxes.
* A TYPICAL EQUITY MUTUAL FUND HAS REALIZED short-term gains and investment income taxed at rates up to 39.6%; realized long-term gains taxed at a maximum rate of 20%; and unrealized gains that are not currently taxed. A more tax-efficient fund emphasizes long-term capital gains.
* THE MANAGER OF A TAX-MANAGED FUND GENERALLY uses a buy-and-hold strategy to emphasize long-term gains over fully taxable dividends and short-term gains. Some tax managed funds use hedging techniques as an alternative to taxable sales.
* TAX-MANAGED FUNDS HAVE SOME SPECIAL RISKS. The funds are relatively new and have a scanty track record. Tax-managed buying and selling might conflict with the manager's style, reducing pretax returns. A tax-efficient strategy may require the fund to hold a security in a down market.
* TAX-EFFICIENT INVESTING ISN'T FOR EVERYONE. It works best for investors who have already contributed the maximum amount to IRAs or 401(k) plans, those seeking a more-liquid alternative to variable annuities or any investor who wants to emphasize long-term appreciation over currently taxable income and gains.
PETER D. FLEMING, CFP, is a senior editor with the Journal. Mr. Fleming in an employee of the American Institute of CPAs and his views, as expressed in this article, do not necessarily reflect the views of the AICPA. Official positions are determined through specific committee procedures, due process and deliberation.
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|Title Annotation:||Mutual Funds; taxation of mutual funds|
|Author:||Fleming, Peter D.|
|Publication:||Journal of Accountancy|
|Date:||May 1, 2000|
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