Easing taxes on mutual funds

Key Points

In my view, mutual funds are a better investment choice than individual stocks for most people. Unless you have both the time and the inclination to devote hours of research identifying the best stocks to buy and sell for your retirement portfolio, it's better to leave that job to the professionals.

Further, mutual funds make it a lot easier to diversify your holdings.

Tax obligations

In a year like 2007, when some stocks enjoyed major gains, managers of active funds are likely to sell selected securities to lock in profits. The capital gains resulting from these sales are passed through to the shareholders, even though the overall returns from the fund may have been poor.

The official numbers aren't in yet, but it's obvious that capital gains distributions for 2007 set another all-time record.

Shareholders of funds held in taxable accounts must pay their share of the tax bill generated by capital gains distributions, even if they had a poor overall year in their personal investment performance - adding insult to injury.

Of course, conditions have to be just right for this to happen. During the sluggish market years of 2000 to 2005, most funds had sufficient capital losses to offset capital gains. Thus, shareholders were spared from year-end tax surprises.

In 2002, Congress passed a law requiring funds to put an explanation of these tax implications in each fund prospectus. However, if you're like most people, you never bother to read the prospectus.

Tax strategies

Once you have a clear idea of how tax considerations affect fund shareholders, it's time to think about strategies that can help you to lessen the tax impact of fund distributions.

First, and perhaps most obvious, none of this gains distribution business affects funds held in tax-deferred accounts, such as IRAs and 401(k)s.

If you have both a taxable and a tax-deferred account in your investment portfolio, you may want to consider limiting your mutual fund purchases to the tax-deferred account. That way, you won't be bothered with tax considerations until you reach age 70.5, when mandatory withdrawals kick in. At that time, your withdrawals will be taxed at your ordinary income rate.

If you currently hold funds in a taxable account, don't despair. The 2007 tax distributions must be looked at in terms of long-range performance. The next time you get a prospectus, take a look to see if 2007 was an unusual distribution year or if it's a perennial problem with that fund.

Selling your funds

If you own a fund in a taxable account that has generated big tax bills most years, keep in mind that you have paid those capital gains taxes each year. Thus, your cost-per-share for tax purposes when you sell the fund must be recalculated.

Most funds provide shareholders with their cost basis (the average cost-per-share recalculated to allow for shares purchased with reinvested distributions).

What all this means is that if you own a fund that has generated big tax bills for you each year, it may be possible to sell that fund without occurring any tax liability, or even result in a loss which could lower your tax bill - even though the current market price per share is higher than you originally paid.

When you get ready to sell a fund, it's important to find out what your adjusted cost basis is so that you can calculate the effect on your tax bill.

So, if you find yourself concerned over this peculiarity in the tax consequences of holding mutual funds, it may be best for you to sell any fund (in a taxable account) that shows a pattern of active trading resulting in big distributions in most years.

Benefits

In any event, you shouldn't allow the capital gains distribution for any one year to frighten you away from ownership of that fund. The long-term performance of the fund is what really matters.

Despite the quirky tax implications that come with the territory when you own mutual funds, I still believe that most investors in stock securities will do better with funds than they will do trying to pick their own stocks. This is especially true of investors who have a clear idea of how tax considerations affect fund owners.

Income taxes have always played a major role in the success or failure of investment portfolios.

In an election year that will usher in a new president, it's always possible that tax obligations will increase - all the more reason for you to learn how to minimize your tax burden legally.

Mr. Lynott is a former management consultant and corporate executive who writes about business and financial topics for various consumer and trade publications. His latest book, Money: How to Make the Most of What You've Got, is available through most bookstores. Reach him at lynott@verizon.net or through his Web site: http://www.blynott.com/