Of Mutual Interest Now that the tax season is over, 3 tax tips for mutual fund investors

By Mark Jewell

AP Personal Finance Writer

BOSTON (AP) -- Duncan Richardson routinely keeps a quarter in his pocket, but it's not spending money. The chief equity investment officer of investment manager Eaton Vance frequently digs the coin out and uses it as a prop to illustrate the drain that taxes can have on investments.

"Investors could be unnecessarily giving away nearly a quarter of every dollar in returns to Uncle Sam," Richardson says.

He notes that the more than 9 percent historic average for stock market returns fails to subtract taxes, not to mention investment fees and inflation.

Richardson's advice: "Keep the quarter. It's yours."

He's not suggesting doing anything suspect. In most circumstances, taxes are unavoidable. At best, the bill can be delayed by using a tax-sheltered account. But many investors -- especially those in higher tax brackets -- don't rely exclusively on an individual retirement account or 401(k), in which earnings can grow tax-free. In fact, about 45 percent of all mutual fund assets are held in taxable accounts.

Although investors can take some relatively simple steps to minimize their tax bills, many fail to do so.

Investors with stock mutual funds held in taxable accounts gave up nearly 1 percentage point of their investment returns to taxes each year from 2000 through 2009, according to a study by fund tracker Lipper Inc. That was in a decade when the Standard & Poor's 500 averaged a 1 percent loss annually, not counting the additional 1 percent hit from taxes. When stocks rallied in the late 1990s, taxes shaved nearly 3 percentage points from returns.

Now that tax-filing season is over, investors might wish to review whether they made any mistakes in 2011 that triggered unexpected capital gains or other tax troubles.

Richardson says tax strategies for fund investors aren't rocket science, yet he sees the same mistakes repeated, year after year. Below are some of the most common:


Some investments are more likely to trigger a tax bill. So keep investments that are likely to generate tax obligations in tax-sheltered accounts like IRAs or 401(k)s, where only withdrawals are taxed.

"It's important to think not just about asset allocation," says Richardson, "but asset location."

Examples of good investments to keep in a tax-sheltered account include taxable corporate bonds and stock funds -- especially those specializing in dividend-paying stocks, or high-turnover mutual funds that trade with unusual frequency.

With a taxable account, you'll pay taxes on sales, dividends and capital-gains distributions each year. So that's where to keep nontaxable investments, such as municipal bonds or muni bond funds. It's also the place to keep stock or bond funds that pursue a specific tax-management mandate. Managers of these funds -- sometimes called tax-advantaged funds -- use a variety of techniques such as holding stocks for longer periods to defer taxable gains.


When mutual fund managers sell investments that have appreciated in value, they pass on the capital gains to investors. It can happen even if a fund lost money overall, since it's the appreciation of the fund's individual, rather than collective, holdings that trigger capital gains. The less trading a fund manager does, the smaller the chance that investors will be stuck with capital gains triggering taxes.

Limit tax consequences by avoiding funds that typically trade most of the investments in their portfolio within a given year -- say, a fund with a turnover ratio higher than 50 percent, which means more than half of the holdings change hands. Read fund reports to find out their turnover ratios, or check websites like Morningstar that provide turnover data for individual funds.


If you're investing using a taxable account, and a mutual fund expects to distribute capital gains, wait until after the distribution date to invest any new cash. If you don't, you could get hit with a tax bill covering gains that you didn't profit from, because they occurred before you invested.

What's more, many investors fail to take advantage of potential benefits from selling investments in their taxable accounts that have lost value. It's a way to offset capital gains elsewhere in their portfolios. Under current tax law, a capital loss deduction allows an investor to claim up to $3,000 more in losses than in capital gains. That means investors can reduce their taxable income dollar for dollar, up to that $3,000 limit.


Avoiding further missteps could become increasingly important because taxes on investment income are set to rise sharply in January, unless Congress acts to extend currently low rates. The outcome won't be known until after the elections. Expect a lame-duck Congress and President Obama to decide in November or December whether to grant another extension for Bush-era tax cuts.

The increases would be steep if nothing is done. For example, dividend income that now tops out at a 15 percent rate could rise to as much as 43.4 percent. That would be the outcome for investors in the top income bracket, if their dividends are taxed as ordinary income at 39.6 percent. The dividend rate would climb to 43.4 percent adding in a 3.8 percent tax on investment income that takes effect in 2013. That's a new tax that Congress approved to help finance President Obama's health care overhaul.

The threat of higher investment taxes is a big issue for Richardson and Boston-based Eaton Vance. The company offers nine stock mutual funds whose managers pursue specific tax-management mandates.

Richardson says it could be difficult in coming years for investors to earn decent returns after inflation and taxes. He believes inflationary pressures are growing, and taxes are likely to increase over the next 12 months or so to help control growing government debt.

"Now is the time," he says, "for taxable investors to think about strategies for maximizing after tax-returns."

If you do, the amount you give back to Uncle Sam might be closer to a nickel or a dime, rather than a quarter.

Published: Mon, Apr 23, 2012


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