If you think Uncle Sam is getting too big a cut of your investment “winnings,” maybe it’s time to change the way you play the game.
It is possible to cut or control your tax burden by altering how you select, shelter and sell stocks and mutual funds. Interested? Here are notable issues to consider:
– Be your own tax master. If controlling taxes is your top priority, buy stocks. That way you determine when you’ll incur capital gains and to what extent you will offset your gains with capital losses. If you buy mutual funds, you relinquish most tax decisions to the fund managers.
– Buy index funds. If you don’t want the responsibility of managing stocks yourself, or you don’t believe you can adequately diversify your portfolio alone, index funds often are tax-efficient. Because they buy stocks to mirror the composition of a specific index, they make fewer trades and tend to pay out less in capital gains than actively managed funds.
– Remodel your portfolio. Selling off your portfolio just because of a tax bill could trigger capital gains taxes that will take years to recoup with a tax-efficient portfolio. Instead, retool so that future contributions are invested in funds that take taxes into account. For instance, if you’re unhappy with an existing fund, don’t continue to reinvest dividends and gains into it. Instead, steer them into a tax-efficient fund.
– Weigh funds for tax efficiency. Certain types of investments tend to be less tax efficient than others. For example, successful “small-cap” funds, which buy stock only in small companies, can ring up heavier capital gains because they are forced to cash out winners that have grown too big for the fund’s charter. Likewise, so-called value funds look for out-of-favor stocks and must sell their winners when the stock market prices them out of the bargain basement. Value stocks also are more likely to pay dividends that are passed along and taxed.
In contrast, “growth” fund managers are on the lookout for companies that are expanding faster than the rest of the economy. They can hang onto their winners (and shelter the gains) and dump the losers (and harvest losses), and they’re less likely to buy dividend-paying stocks.
– Take full advantage of taxable and tax-deferred accounts. As a rule of thumb, put tax-efficient funds and growth funds in taxable accounts. But fire up your tax-deferred accounts with value funds, small-cap funds, funds that pass along large amounts of income and dividends, and funds that have amassed large piles of capital gains.
– Consider a fund’s “life cycle.” A fund’s tax efficiency diminishes over time because older funds tend to have more redemptions as shareholders cash out, said Mark P. Hurley, chief executive of Undiscovered Managers LLC, a Dallas mutual fund company. So, it can be to your advantage to invest in young, growing mutual funds that are clones of successful funds or are run by managers with strong records.
The reason centers on who will pay the capital gains. Until the manager sells a winner, the gain is “unrealized” or “embedded.” But once the stock is sold, the capital gain must be passed along to all shareholders.
If you invest early, before the portfolio appreciates, late-entry investors will share the bill for part of your embedded capital gains. If you buy in late, you’ll inherit someone else’s tax liability.
“It’s a race,” Hurley said. “Whoever gets in first gets the best taxes. The only way someone gets a better tax deal is for someone else to get a worse tax deal. It’s a zero-sum game.”
– Evaluate mutual fund “turnover.” This is a measure of how actively the fund manager is buying or selling stocks–or turning over the portfolio. High turnover could indicate a manager is incurring commissions and gains, while low turnover could indicate the manager has a buy-and-hold mentality.
To determine a fund’s turnover, consult the prospectus or contact the fund family. Another option is visit a public library and read fund reports by Morningstar Mutual Funds or Value Line Publishing Inc. Or browse the Web at investment sites such as Morningstar (www.morningstar.net), Charles Schwab (www.schwab.com) or the Securities and Exchange Commission (www.sec.gov/index.html).
Turnover is not an entirely reliable or predictable measurement, however. For example, Fidelity Dividend Growth boasted a 140 percent after-tax return for the five years ended in 1997, despite a 141 percent turnover ratio in 1997, according to a study by Undiscovered Managers. Meanwhile, Anchor Capital Accumulation eked out only a 37 percent return despite a 4 percent turnover rate.
High turnover doesn’t indicate whether the trades unleashed short- or long-term gains–or even losses. Low turnover could mean the manager is sitting on gains that you would inherit if you invested.
Because of the formula for calculating turnover, two funds could each have zero turnover if one exclusively made new purchases and the other exclusively sold, said Joel Dickson, a principal with Vanguard Group, the Pennsylvania mutual fund giant. The latter fund, however, could pass on mountains of capital gains.
– Examine the fund manager’s tax record. Develop a sense of the manager’s approach to investing and taxes. Start by looking for a manager who has a reliable long-term record of outstanding pretax performance. After all, after-tax returns are an outgrowth of pretax returns.
Beyond that, determine whether the manager consistently keeps taxes low. Although fund managers are rewarded and ranked based on pretax returns, many also operate in a tax-efficient manner that produces admirable after-tax returns.
Look in the prospectus or Morningstar or Value Line research reports for details about what strategies a manager uses. Typically, that means selling high-cost shares first, offsetting losses against gains and avoiding stocks that pay dividends. But some also levy fees to discourage shareholders from bailing out and forcing stock sales. For instance, American Century Tax-Managed Fund charges a 2 percent fee on any withdrawals made within a year.
Read the prospectus to see if such strategies are mandated. If they’re not, you must decide whether you believe the manager is likely to continue his or her tax-smart habits.
“I would watch out for funds that don’t say anything about being managed with tax efficiency in mind,” said Russ Kinnel, director of fund analysis for Morningstar in Chicago. “For a lot of those funds, it might be a happy accident. It’s only the tax-managed funds that are consistent.”
– Evaluate unrealized gains. This measure of the amount of capital gain, or growth, of the fund’s stocks generally indicates whether the manager is a savvy buy-and-hold stock picker.
But it also could be a ticking time bomb if you buy shares. That’s because gains are distributed to all shareholders, regardless of when they bought in. Indeed, it’s possible that you could buy into a high-flying fund just as it loses altitude but get stuck with a capital gains bill.
A heavy load of unrealized gains also could mean the fund has “stale money” because the manager can’t sell certain stocks without unleashing big gains, said Michael Lipper, chairman of Lipper Inc., a New York investment tracking firm. That could drag down performance.
A low ratio of embedded gains doesn’t guarantee low taxes, however. It could mean the manager just has a habit of passing along all the gains every year, leaving you with an annual tax bill, Dickson said.
