Taxation Of Mutual Fund Income

Investment returns of mutual funds are granted "pass-through status" under the U.S. tax code, meaning that taxes are paid only by the investor in the mutual fund, not by the fund itself. The income is treated as passed through to the investor as long as the fund meets several requirements, most notably that at least 90% of all income is distributed to shareholders. In addition, the fund must receive less than 30% of its gross income from the sale of securities held for less than three months, and the fund must satisfy some diversification criteria. Actually, the earnings pass-through requirements can be even more stringent than 90%, since to avoid a separate excise tax, a fund must distribute at least 98% of income in the calendar year that it is earned.

A fund's short-term capital gains, long-term capital gains, and dividends are passed through to investors as though the investor earned the income directly. The investor will pay taxes at the appropriate rate depending on the type of income as well as the investor's own tax bracket.2

The pass through of investment income has one important disadvantage for individual investors. If you manage your own portfolio, you decide when to realize capital gains and losses on any security; therefore, you can time those realizations to efficiently manage your tax liabilities. When you invest through a mutual fund, however, the timing of the sale of securities from the portfolio is out of your control, which reduces your ability to engage in tax management. Of course, if the mutual fund is held in a tax-deferred retirement account such as an IRA or 401(k) account, these tax management issues are irrelevant.

A fund with a high portfolio turnover rate can be particularly "tax inefficient." Turnover is the ratio of the trading activity of a portfolio to the assets of the portfolio. It measures the fraction of the portfolio that is "replaced" each year. For example, a $100 million portfolio with $50 million in sales of some securities with purchases of other securities would have a turnover rate of 50%. High turnover means that capital gains or losses are being realized constantly, and therefore that the investor cannot time the realizations to manage his or her overall tax obligation. The nearby box focuses on the importance of turnover rates on tax efficiency.

In 2000, the SEC instituted new rules that require funds to disclose the tax impact of portfolio turnover. Funds must include in their prospectus after-tax returns for the past one, five, and 10-year periods. Marketing literature that includes performance data also must include after-tax results. The after-tax returns are computed accounting for the impact of the taxable distributions of income and capital gains passed through to the investor, assuming the investor is in the maximum tax bracket.

2 An interesting problem that an investor needs to be aware of derives from the fact that capital gains and dividends on mutual funds are typically paid out to shareholders once or twice a year. This means that an investor who has just purchased shares in a mutual fund can receive a capital gain distribution (and be taxed on that distribution) on transactions that occurred long before he or she purchased shares in the fund. This is particularly a concern late in the year when such distributions typically are made.

LOW "TURNOVERS" MAY TASTE VERY GOOD TO FUND OWNERS

With lower capital-gains tax rates in store, mutual-fund investors are going to be rewarded by portfolio managers who believe in one of the stock market's most effective strategies: buy and hold.

This is because, under the new federal tax agreement, investors will face far lower taxes from stock mutual funds that pay out little in the way of dividends and hold onto their gains for as long as they can.

So, how can you find such funds? The best way is to track a statistic called "turnover." Turnover rates are disclosed in a fund's annual report, prospectus and, many times, in the semiannual report.

Turnover measures how much trading a fund does. A fund with 100% turnover is one that, on average, holds onto its positions for one year before selling them. A fund with a turnover of 50% "turns over" half of its portfolio in a year; that is, after six months it has replaced about half of its portfolio.

Funds with low turnover generate fewer taxes each year. Consider the nation's top two largest mutual funds, Fidelity Magellan and Vanguard Index Trust 500 Portfolio. The Vanguard fund, with an extremely low turnover rate of 5%, handed its investors less of an annual tax bill the past three years than Magellan, which had a turnover rate of 155%. Diversified U.S. stock funds on average have a turnover rate of close to 90%.

Vanguard Index Trust 500 Portfolio, at $42 billion the second-largest fund in the country, has low turnover, and as an index fund you'd expect it to stay that way. Index funds buy and hold a basket of stocks to try to match the performance of a market benchmark—in this case, the Standard & Poor's 500 Index.

But turnover isn't a constant. Though Fidelity Magellan, at $58 billion the largest fund in the nation, shows a high turnover rate of 155%, that's because its new manager Robert Stansky has been revamping the fund since he took over from Jeffrey Vinik last year. The turnover rate could well go down, along with Magellan's taxable distributions, as Mr. Stansky settles in.

It makes sense that turnover would offer clues about how much tax a fund would generate. Funds that just buy and hold stocks, such as index funds, aren't selling stocks that generate gains. So an investor has to pay taxes only when he sells the low-turnover fund, if the fund has appreciated in value.

On the other hand, a fund that trades in a frenzy could generate lots of short-term gains. For instance, a fund sells XYZ Corp. after three months, realizing a gain of $1 million. Then it buys ABC Corp., and sells it after two months, realizing a gain of, say, $2 million. By law, these gains have to be distributed to investors, who then have to pay taxes on them, and since they're short-term gains, the tax rate is higher.

Fans of low-turnover funds say that, in general, such portfolios have had higher total returns than highturnover funds. There are always exceptions, of course: Peter Lynch, former skipper of giant Fidelity Magellan fund, racked up huge returns while trading stocks like they were baseball cards. Still, one reason low-turnover funds might have higher returns is that they don't incur the hidden costs of trading, such as commissions paid to brokers, that can drain away a fund's returns.

Source: Robert McGough, "Low 'Turnovers' May Taste Very Good to Fund Owners in Wake of Tax Deal," The Wall Street Journal, July 31, 1997, p. C1. Reprinted by permission of The Wall Street Journal, © 1997 Dow Jones & Company, Inc. All Rights Reserved Worldwide.

CONCEPT CHECK ^ QUESTION 3

An investor's portfolio currently is worth $1 million. During the year, the investor sells 1,000 shares of Microsoft at a price of $80 per share and 2,000 shares of Ford at a price of $40 per share. The proceeds are used to buy 1,600 shares of IBM at $100 per share.

a. What was the portfolio turnover rate?

b. If the shares in Microsoft originally were purchased for $70 each and those in Ford were purchased for $35, and the investor's tax rate on capital gains income is 20%, how much extra will the investor owe on this year's taxes as a result of these transactions?

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