Mutual Funds: When Taxes Can Hurt


As you’ve gone through the latest annual reports from your mutual funds and considered how to apply what you learned in your investment strategy and tax planning, have you noted that their basic features are not the same? For example, have you noted that some reports have a feature that others don’t: a comparison of pre-tax and after-tax returns?

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Have you wondered why?

The answer lies not only in fund decisions to provide these data elsewhere but also in the apparent ambivalence of the Securities and Exchange Commission, an agency of the government whose taxes are at the heart of the matter, about ensuring that people who own mutual funds in taxable accounts know how much of an impact they have.

The SEC knows.

On January 18, 2001, the Commission began a 54-page release, announcing it had just adopted a final rule aimed at improving “disclosure to investors of the effect of taxes on the performance” of mutual funds with this statement: “Taxes are one of the most significant costs of investing in mutual funds through taxable accounts.” Such accounts are of substantial importance among household assets.

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Given all the attention paid 401(k) accounts and IRAs by presidents, members of Congress, media and others when the stock market coughs, it may amaze some to read in the release that, according to the Investment Company Institute, almost 40% of non-money market accounts held by individuals were held in taxable accounts at the end of 1999. (Ten years later, the ICI reports, it was still 38%.)

Noting that many investors are surprised when they learn that “they can owe substantial taxes on their mutual fund investments that appear to be unrelated to the performance of the fund,” the Commission showed it knew why taxes can hurt.

“Even if the value of a fund has declined during the year, a shareholder can owe taxes on capital gains distributions if the portfolio manager sold some of the fund’s underlying portfolio securities at a gain,” it explained.

In adopting a rule which it had proposed for public and industry comments on March 15, 2000, the Commission acted after funds’ total capital gains distributions to taxable and tax-deferred accounts had spiked to a record in 1999 and a new record in 2000.

Shareholders made their views known, and some in Congress acted promptly in response. On March 11, 1999, the late Rep. Paul E. Gillmor (R-OH) introduced the Mutual Fund Tax Awareness Act of 2000, requiring the SEC to do what it did. The House of Representatives approved the bill, 358 to 2, on April 3, 2000, but it died subsequently in the Senate.On June 22, 2000, Rep. Jim Saxton (R-NJ), introduced a different bill to allow investors to defer taxes on at least some of their distributions, but it died in the House. [So have similar bills by Saxton, Rep. Paul Ryan (R-WI) and Sen. Mike Crapo (R-ID) in subsequent years.]The SEC’s rule required publication of a table that was elegant in its simplicity. It would provide standardized average annual pre-tax total returns for one, five and ten years and standardized average annual after-tax returns, calculated in two ways: returns after taxes on distributions and returns after taxes on distributions plus the assumed sales of fund shares. (The rule required funds to use the maximum rates in each period. Shareholders taxed at lower rates would have to adjust the data accordingly.)

Divide the return after taxes on distributions by the pre-tax return, and you get a measure of a fund’s tax efficiency (or inefficiency)

Not so simple was the Commission’s decision-making on where funds should run the table. Having a choice of an annual report, prospectus, statement of additional information, and fund profile, it picked the performance table in a prospectus’ risk/return summary and the less widely distributed profile. Elaborating on why the Commission backed away from its original proposal to include the table in management’s discussion of fund performance “which is typically contained in the annual report,” it said:

* “…commenters observed (that) existing shareholders already receive detailed information that allows them to determine the tax impact of their investment in the fund.” (The information, according to a footnote, is the IRS Form 1099—DIV, which does provide long-term capital gains distributions but does not break out the more highly taxed short-term capital gains distributions, and, of course, it does not calculate a hypothetical after-tax return.)

* “They also typically receive on an annual basis an updated prospectus.” (Our mailbox does not “typically” receive updated prospectuses from most funds. Funds are legally required to send prospectuses only to existing shareholders who buy additional shares.)

So…if you find a table in an annual, the fund volunteered to insert it—perhaps to prove it’s tax-efficient.

What do you think?

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