Pay less to the IRS with tax-managed mutual funds

January 27, 2011

Werner Renberg is a writer and author based in Chappaqua, N.Y. He is the author of four books, including All About Bond Funds: A Complete Guide for Today’s Investors. The opinions expressed are his own.

A man holds his envelopes as he waits in line to mail his family's income tax returns at a mobile post office near the Internal Revenue Service building in downtown Washington, April 15, 2010.    REUTERS/Jonathan Ernst    If you own equity or mixed-asset mutual funds in taxable accounts, one thing is certain: Whatever the top income tax rate on capital gains that President Barack Obama and Congress will agree on for 2013 and beyond, it will continue to hit you in two ways — and possibly even a third:

1. You, of course, will owe income tax when you sell mutual funds’ shares out of taxable accounts if your capital gains exceed your capital losses.

2. You also will owe income tax when funds sell securities and have net capital gains at year’s end, requiring them to credit you with your portions of the taxable distributions even if you didn’t sell one share — and even if your funds values dropped.

3. You would suffer a third strike if all your net capital gains and capital gains distributions lift your adjusted gross income (IRS Form 1040’s Line 37) enough to put you into a higher tax bracket.

Can you do anything to have more of your taxable retirement portfolio continue to work for you and pay less to the IRS? Perhaps. You could move money into one or more tax-managed equity or mixed-asset funds. Such funds tend to have two goals:

•  Maximizing after-tax returns by (a) offsetting capital gains with capital losses to reduce, if not to avoid, long-term capital gains distributions and (b) using other tactics, such as keeping stocks targeted for sale for a year until they become long-term holdings to avoid highly taxed short-term capital gains distributions. For income, these funds prefer stocks that pay lower-taxed qualified dividends and may also invest in federally tax-free municipal bonds.

•  Outperforming appropriate broad stock market benchmarks, as well as, pre-tax returns of peer funds in their investment objective categories. The goals may conflict. As Brown Brothers Harriman says in its Core Select prospectus, “managing the Fund for after-tax returns may hurt the Fund’s performance on a pre-tax basis.”

Whatever the funds are called — “tax-managed,” “tax efficient,” or something else — the SEC checks whether their investment strategies are consistent with their names.

There are currently 55 funds with “tax-managed attributes,” according to Lipper, a unit of Thomson Reuters. The oldest is the $4.6 billion Schwab 1000 Index Fund, launched in April 1991, and the largest, the $6.4 billion Vanguard Tax-Managed International Fund. (Another 50 have been liquidated or merged with siblings over the years.)

Index funds are commonly considered tax efficient, primarily because they have lower portfolio turnover rates, and thus, lower potential for realizing taxable capital gains. They only have to sell stocks when index sponsors remove companies from their index lists and replace them, which is not often. An index stock’s price may be plunging, but they must hang on. They also must own dividend-paying stocks and make taxable income distributions.

Lipper considers index funds tax-managed as well as tax efficient when they say they are, as Schwab 1000 and Schwab Total Stock Market Index Fund do. In their prospectuses, the firm cites its “tax-efficient management strategy” and “techniques…to enhance…after-tax performance.”

If some tax-managed funds have dropped the word “tax” from their names, as American Century Capital Value has, it’s to avoid inferences that it was “a non-equity investment” — perhaps a tax-free municipal bond fund — and “to highlight the…primary goal of capital growth.”

Of 24 fund groups offering the 55 tax-managed funds for individual and/or institutional investors, Eaton Vance has the most: 10. AllianceBernstein, Dimensional Fund Advisors, and Vanguard have five each. Lipper reported their combined assets reached $50.7 billion as of November 30, led by Vanguard’s $14.8 billion, DFA’s $9.1 billion, and Eaton Vance’s $8.6 billion.

The funds give investors a large selection of diversified domestic and foreign equity portfolios with a variety of investment objectives, characterized by a range of risk levels, and classified according to companies’ capitalization (or “cap”) and style: growth-oriented, value-oriented, or a variable blend of both, which Lipper calls “core.”

U.S. large-caps had the largest number, 18, and total assets, $14.9 billion. Eleven multi-cap funds’ had assets totaling $10.2 billion and seven international funds, $13.6 billion. In each class, investors had more money in core funds than in growth or value funds.

While you will want to study historic performance of funds in the investment objective categories that interest you, when considering tax-managed funds you need to be concerned with how tax efficient they are — that is, how much of their pre-tax returns you can “take home” after taxes.

To determine which appealing tax-managed funds are more tax efficient — and to learn more about them — check them out on Lipper’s free online Fund & ETF Screener. It should be helpful with your decision making.

This article tells you how the Screener works.

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