When a funds manager factors
taxes into investment decisions,
A Taxing Problem
BY PETER D. FLEMING
| EXECUTIVE SUMMARY
INCOME TAXES CAN EAT UP A SUBSTANTIAL PORTION
of the investment return on an equity
mutual fund. For tax conscious investors,
tax-managed mutual funds offer a relatively
recent solution to this problem. In 1998 the
average tax-managed fund lost only 1% of its
return to taxes.
- A TYPICAL
EQUITY MUTUAL FUND HAS REALIZED
short-term gains and investment income taxed at
rates up to 39.6%; realized long-term gains
taxed at a maximum rate of 20%; and unrealized
gains that are not currently taxed. A more
tax-efficient fund emphasizes long-term capital
- THE MANAGER OF A
TAX-MANAGED FUND GENERALLY uses a
buy-and-hold strategy to emphasize long-term
gains over fully taxable dividends and
short-term gains. Some tax-managed funds use
hedging techniques as an alternative to taxable
- TAX-MANAGED FUNDS
HAVE SOME SPECIAL RISKS. The funds
are relatively new and have a scanty track
record. Tax-managed buying and selling might
conflict with the managers style, reducing
pretax returns. A tax-efficient strategy may
require the fund to hold a security in a down
INVESTING ISNT FOR EVERYONE. It
works best for investors who have already
contributed the maximum amount to IRAs or 401(k)
plans, those seeking a more-liquid alternative
to variable annuities or any investor who wants
to emphasize long-term appreciation over
currently taxable income and gains..
PETER D. FLEMING, CFP, is a senior editor with the
Journal. Mr. Fleming in an employee of
the American Institute of CPAs and his views, as
expressed in this article, do not necessarily
reflect the views of the AICPA. Official positions
are determined through specific committee
procedures, due process and deliberation.
ach January millions of mutual
fund investors open their 1099s to face the grim news of how
much taxable income and gain they will have to report. But
in the past five years no new type of fund has provided more
good news for certain investors than tax-managed mutual
When an investor holds mutual funds
outside IRAs and other tax-deferred retirement accounts, the
cost of maintaining such investments includes taxes as well
as commissions and management fees. Many mutual fund
shareholders find taxes on interest, dividends and realized
gains are the largest cost they face. With most
distributions reinvested in additional shares, investors
have to dig deep into their pockets to pay the tax bill.
| Tax-Efficient Investing
| In a 1999 report,
Tax Managed Mutual Funds and the Taxable Investor,
KPMG looked at the tax efficiency of mutual
funds, the advantages of managing an equity mutual
fund for aftertax returns and the impact tax
efficiency can have on net aftertax returns. KPMG
found that a long-term taxpaying investor can
achieve higher aftertax investment returns from a
tax-managed equity fund than from a conventional
equity fund managed without regard to tax
considerationsassuming the same level of pretax
Copies of the study are available from
Eaton Vance Distributors by calling
1-800-225-6265, ext. 8129 or e-mailing
Each year, fund
sponsors introduce hundreds of new mutual funds. (Today
there are more than 10,000 funds in existence.) For tax
conscious investors, tax-managed mutual funds are one
solution to the problem of taxable mutual fund
distributions. These funds seek to invest in a way that will
minimize taxes and maximize long-term growth. With tax rates
on net investment income and realized short-term gains as
high as 39.6% and realized long-term gains taxed at a top
rate of 20%, investing in a tax-managed fund can help an
investor protect a substantial portion of his or her
Although there are fewer than
100 tax-managed mutual funds (see exhibit 1 for a sampling),
their stated goal of reducing the impact of federal and
state income taxes on fund returns gives clients who already
contribute the maximum amount to tax-favored IRAs or 401(k)
plans another low-tax way to invest in the stock market.
| Exhibit 1: A Sample of Tax-Managed
Mutual Funds |
As CPAs try to keep pace with
the best investment vehicles to help clients realize their
goals, tax-managed mutual funds are an increasingly
important way clients can hold down taxes, leaving more for
retirement, college funding and other key objectives. Here
are some of the things CPAs will want to know about
tax-managed mutual funds before recommending that clients
add them to their portfolios.
Tax-managed mutual funds
operate the way most other mutual funds do. The difference
is in how the funds are managed: Most fund managers tend to
sell stocks with the lowest cost basisand the highest
profitto boost returns, but tax-managed fund managers
follow a different strategy, emphasizing aftertax returns.
The aftertax return an investor earns from a mutual
fund investment is a function of four factors:
The investors own tax circumstances (tax
bracket, filing status).
pretax returns the fund earns.
The funds tax efficiency.
investors time horizon.
efficiency is determined by the makeup of the funds
returns. A typical equity fund has realized short-term gains
and investment income that are taxed as ordinary income
(maximum rate, 39.6%); realized long-term gains that are
taxed at favorable capital gains rates (maximum rate, 20%);
and unrealized capital gains that are not currently taxable.
A tax-efficient fund has more long-term capital gains and
less investment income and short-term gains.
avoid having to pay taxes at the fund level, a mutual fund
must distribute a minimum of 90% of its income (net of fund
expenses) and realized capital gains to shareholders. An
investor pays taxes on all distributions, whether he or she
elects to take them in cash or reinvest them in additional
shares. (For more on the taxation of mutual fund
distributions, see Mutual Fund Tax Trap.)
| Mutual Fund Tax Trap |
When a mutual fund experiences net redemptions
(shareholder redemption requests exceed new
investments), the funds remaining shareholders
may fall victim to a potentially large tax trap.
The trap results from the tax treatment the
Internal Revenue Code affords mutual funds and
852(b)(3)A imposes a tax on the excess, if any, of
a funds net realized capital gains over the
deduction for capital gains the fund distributes
to shareholders. To avoid this tax at the fund
level, it is normal industry practice for a fund
to make a capital gain distribution that is
substantially equal to its net realized capital
gains. Mutual funds normally make one such
distribution per year, usually around the end of
the funds fiscal year. Only shareholders who own
the fund on the record date receive the
After several years of
investment growth, many mutual funds have
experienced substantial appreciation in the value
of their portfolio. (CPAs can find information on
a particular funds unrealized gains in
Morningstar. ) As a fund approaches
yearend, it must distribute all of the gains it
was forced to realize to meet shareholder
redemption requests. Although this distribution is
taxable to the remaining shareholders, the
redeeming shareholders recognize no tax
consequences (other than any gain or loss on the
sale of their shares). The redeeming shareholders
not only force the fund to liquidate securities
and realize substantial capital gains, but they
shift the tax consequences of this gain to the
planners recommend that clients focus on long-term
goals and ignore short-term market fluctuations.
They typically advise against attempting to time
the market. But as the above scenario illustrates,
this may not always be the best advice from a tax
perspective. When a client owns shares in a mutual
fund that is experiencing substantial net
redemptions and also has significant unrealized
appreciation, the potential exists for a large tax
liability. Financial planners may want to
recommend the client liquidate his or her
investment in such a fund before yearend to avoid
capital gain distributions.
financial planners know to advise a client to
avoid purchasing a mutual fund just before it is
due to make a capital gain distribution. For
clients considering investing in a fund that has
experienced large net redemptions, that advice is
even more astute. In fact, it might be prudent for
a planner to anticipate the problem of potential
capital gain distributions from new mutual fund
purchases much earlier in the year, by keeping
tabs on the funds net redemptions.
Phyllis Bernstein, CPA, director, AICPA
personal financial planning division
Taxes have a substantial negative effect on mutual
fund returns. For example, if an equity fund returns 10% in
a particular year, deriving 3% of that return from dividends
and short-term gains, 5% from realized long-term gains and
2% from unrealized gains, its return shrinks to only 7.8%
after federal taxes, as shown in exhibit 2. That means 22%
of the funds return has been lost to taxesbefore even
considering the impact of any state or local taxes. (In high
tax states such as New York or California investors see
their return shrink even more.) Although most mutual fund
managers pay little attention to how taxes can cut into a
funds return, tax-managed fund managers must balance
investment and tax considerations and evaluate how their
trading will affect a typical shareholders tax liability.
| Exhibit 2: Impact of Taxes on Fund
| || Pretax
Tax Rate ||
Aftertax Returns |
| Total return || 10.0%
|| || 7.8%
| Dividends and short-term
gains || 3.0% || 39.6%
|| 1.8% |
| Long-term gains || 5.0%
|| 20.0% || 4.0%
| Unrealized gains
|| 2.0% || 0.0% ||
A mutual funds turnover ratehow frequently the fund
manager buys and sells securitieshas a substantial impact
on an investors aftertax return. Tax-managed funds
generally have low turnover rates. Since most fund managers
look to maximize pretax returns, they dont even consider
the tax impact of their trading frequency. The result is
that an investors aftertax returns can be significantly
lower than the funds advertised pretax returns.
Lipper Analytical Services, Inc., says the annual portfolio
turnover rate for the average equity fund is 86%; for the
average growth fund, the rate is 81%. A high turnover rate
means there is the potential for the fund to realize more
taxable gains. According to Morningstar, Inc., the average
diversified equity mutual fund gained 14.3% in 1998 and lost
12% of that return to taxes. In contrast, the average
tax-managed fund gained 21.57% in the same period and lost
only 1% to taxes.
Historically, mutual fund performance has been measured
by pretax returns. But with approximately 60% of mutual
funds in taxable accounts, this may not be the best way to
judge true performance. With the tremendous stock market
gains in the latter part of the 1990s and after several
years of record mutual fund distributions, investors have
become more conscious of aftertax returns.
Despite the option to follow tax-efficient strategies when
investing in individual stocks and bonds on their own, many
investors prefer the ease of mutual fundsprofessional
management, greater diversification, improved liquidity. A
tax-managed fund, with a low turnover rate, can
significantly increase returns. As exhibit 3, below,
illustrates, if a high-bracket investor holds a
high-turnover stock fund for 30 years before selling it, a
$25,000 investment might grow to $187,888. However, if the
same investor uses a low-turnover fund, the same investment
could grow to $335,930.
| Exhibit 3: Tax-Managed vs.
Non-Tax-Managed Funds |
- $25,000 investment.
- 10% annual rate of return.
- 8% annual turnover in
annual turnover in high-turnover
- Taxes are paid
out of account each year, with
remaining income invested in
year three, annual distributions are
assumed to be 50% ordinary income and
50% long-term gains.
long-term capital gain rate upon
| Source: State
Street Research, Boston. |
Even Congress is concerned
that high pretax returns may be overstated and potentially
misleading to investors. The House of Representatives is
considering a bill to require fund sponsors to make improved
disclosures. (See Congress Chimes In, for more details.)
| Congress Chimes In |
Congress is concerned that mutual fund performance
figures dont give the true picture of the effect
taxes have on investor returns. In March 1999,
Representative Paul Gillmore (R-Ohio) introduced
HR 1089, the Mutual Fund Tax Awareness Act of
The bill expresses concern that
- The average mutual fund investor
loses up to 3% of a funds return to taxes every
- Portfolio turnover has nearly
tripled, to almost 90%, from 30% 20 years ago.
- Average capital gain distributions
from growth funds have more than doubled in the
last 10 years.
sponsors believe improved disclosure of tax
efficiency by mutual fund companies would allow
shareholders to compare aftertax returns to raw
performance and help them determine if a fund
manager tries to minimize shareholder tax
If passed, the
legislation would require the SEC to revise
regulations under the Investment Company Act of
1940 mandating improved disclosure methods in
prospectuses and annual reports of the aftertax
effects of portfolio turnover on mutual fund
returns. Congress has held committee hearings on
the bill, but no formal action has yet been taken.
SEC Chairman Arthur Levitt, Jr., is also speaking out on the
tax implications of mutual fund investing. Many investors
lack a clear understanding of the impact taxes have on
their mutual fund returns, he says. In a February speech
before the Mutual Fund Directors Education Council, Levitt
cited the estimated $34 billion that stock and bond fund
shareholders paid in taxes on fund distributions in 1997. On
March 15 the SEC issued proposed rules requiring companies
to disclose aftertax returns in fund prospectuses. Funds
would not be required to include aftertax returns in
advertising or other sales materials. The deadline for
commenting on the proposed rulesavailable at
www.sec.gov/rules/proposed/33-7809.htm is June 30.
THE RIGHT STRATEGY
the manager of a tax-managed fund go about minimizing taxes?
For example, here are some techniques Eaton Vance
Tax-Managed Emerging Growth Fund says it uses to achieve
tax-efficient management. The fund
Invests primarily in lower-yielding growth stocks.
Employs a long-term approach to investing.
Tries to avoid net realized
appropriate, sells stocks trading below their tax cost
(basis) to realize losses.
selling appreciated stock, it selects the most
tax-favored share lots (those with the highest cost
tax-advantaged hedging techniques as an alternative to
employ similar strategies. State Street Research Legacy Fund
uses what it calls a buy-and-hold approach to allow the fund
to focus on long-term capital appreciation while
reducingalthough not eliminatingtaxable capital gains
distributions. The T. Rowe Price Tax-Efficient Balanced Fund
adds tax-free municipal bonds to the mix. Its objective is
to provide investors with attractive long-term returns on
an aftertax basis with a balanced portfolio of stocks and
municipal bonds. The fund invests a minimum of 50% of its
total assets in tax-exempt securities.
large unexpected redemptions could disrupt this buy-and-hold
strategy, some tax-managed funds impose a redemption penalty
to discourage investors from making large withdrawals that
might force management to sell securities to raise cash.
RISK AND RETURN
any investment strategy, tax-efficient investing carries
risks as well as rewards. In evaluating tax-managed mutual
funds for their clients, CPAs should use the same criteria
they would use to judge any other fund, including
The track record, background and experience
of the fund manager.
Risk relative to the
funds peer group.
consistency. (Does the portfolio stick with its selected
There are, however,
some special risks associated with tax-managed funds that
CPAs should consider:
funds are relatively new, and many have little or no
track record investors can use to judge performance,
risk and other factors.
Tax-managed buying and selling might conflict with the
managers style, reducing pretax returns.
Over time, a tax-managed fund may accumulate a
large portfolio of unrealized gains. Investors in such
funds face the risk the fund will decide to realize some
or all of these gains and pass them through to
frequently use various hedging strategies to protect
gains instead of selling shares. These strategies leave
the fund open to large potential losses.
The funds long-term investment strategy may
require it to hold a security in a down market when
stock prices are declining.
Its also important to remember that an investor who doesnt
pay Uncle Sam now is likely to have to pay later. Many
tax-managed funds achieve their returns through unrealized
capital gains, which means the value of the funds shares
continues to grow. When an investor decides to sell his or
her shares, the gain on disposal could be much higher than
it might be with a mutual fund that had distributed its
gains over time. Still, depending on the investors holding
period, the gain on sale is likely to be taxed at favorable
long-term capital gain rates. Such a scenario also puts the
investor in the drivers seat; he or she decides when to
realize and pay taxes on capital gains, rather than the fund
THEY GOOD FOR?
Tax-efficient investing isnt good, or even
necessary, for everyone. Low-bracket taxpayers generally
will do better investing in more conventional mutual funds,
since taxes arent a big concern. Tax-deferred retirement
accounts also are likely to obtain higher returns from other
kinds of funds since they dont pay taxes currently. There
are, however, some clients a CPA will find particularly
suited to tax-managed mutual funds, including
Tax-conscious investors who already have
contributed the maximum amount to IRAs, Keoghs or 401(k)
plans, or those who arent eligible to contribute.
Investors seeking a flexible, more-liquid
alternative to variable annuities.
Irrevocable trusts looking for capital appreciation
with minimal tax consequences.
Those seeking funding vehicles for money transferred to
children under the Uniform Transfer to Minors Act, where
income earned by children under age 14 is generally
taxable at the parents tax bracket.
Any investors who want less taxable income, such as
an older client seeking to lower his or her investment
income and thereby minimize the amount of Social
Security benefits subject to tax.
TAX-MANAGED, NOT TAX-FREE
recommending tax-managed mutual funds to clients, its
important that CPAs make sure clients understand that
tax-managed does not mean tax-free. The funds seek to
minimize taxes, not eliminate them. With the stock market
still providing the potential for substantial gains, few
investors can afford to overlook the fact that taxes reduce
their mutual fund returns, and tax-managed funds provide one
solution to a vexing problem. Some investors, however, still
havent gotten the message. A July 1999 Mutual Fund
Magazine survey found that taxes arent a concern
for most mutual fund investors. In the poll, only one in
eight investors put taxes near the top of a list of
important considerations in judging a mutual funds appeal.
As a result, CPAs may find they have to save these clients
from themselves by educating them about the impact taxes can
have on mutual fund returns. If the growing number of
tax-managed funds is any indication, more and more clients
are getting the message every day.
| Keeping More Money in Shareholders
For Armin J. Lang,
vice-president and portfolio manager of Eaton
Vances Tax-Managed International Growth Fund,
tax-managed investing is a 24-hour-a-day job.
Because the fund concentrates on overseas
companies, Lang must work when the global markets
are open. Sometimes, he says, it seems as though
my office is my home.
In Langs mind,
the essence of tax-managed investing is fairly
simple: You want to make sure the money ends up
where it belongsin the shareholders pocket. From
what Ive seen recently, more and more mutual fund
investors end up giving money at the end of the
year to their least favorite charity, Uncle Sam.
And that, Lang says, is something he tries to
avoid by any means. If you look at the capital
gains distribution of our tax-managed equity fund,
it is zero, was zero and will be zero. That means
the shareholder gets to keep all of the money he
or she deserves.
Lang says tax-managed
investing in an international environment is much
the same as it is domestically. Theres virtually
no difference. It comes down to the same
characteristics. You want to be a long-term
investor, and that holds true for both U.S. and
about the difficulties of tax-efficient investing,
Lang says it helps to have a strong investment
philosophy. My philosophy is very much long-term.
If I buy a stock today, I expect to hold it for at
least five years, if not more. If you look at the
average portfolio manager, international or
domestic, I dont think theres anyone who has a
five-year time horizon. The bottom line, Lang
says, is the difference between buying companies
and trading stocks.
Lang is bullish on
the long-term prospects for tax-managed investing.
Five years from now, Im convinced no one will
look exclusively at pretax returns. Everyone will
look at aftertax returns, even in funds that
arent necessarily managed with that goal. Lang
goes so far as to predict that fund sponsors will
offer qualified and nonqualified mutual funds,
with the latter managed to be more tax efficient.
And he points out that the SEC is on the case
following Chairman Arthur Levitt Jr.s February
comments promising stricter disclosure of aftertax
In looking to the future,
Lang offers this example: When you receive your
paycheck, you dont just look at the top line
number, you look at the bottom line, your
take-home pay. Thats exactly whats going to
happen with mutual funds. If you own a fund that
returns 45% and you check the bottom line and see
the aftertax return is also 45%, youre happy. If
you have another fund that returns 15% and after
paying taxes on capital gain distributions the
bottom line is that the fund returns only 5%, you
know you have a problem. This will lead investors
to tax-managed funds.
Over the last
five years, Lang says, investors have had the
benefit of decent stock market returns. He cites
an investor in a domestic equity fund that returns
20%. If you give up 250 basis points of that
return to taxes, at least youll still have 17.5%
left. In the next five years, Lang says, market
gains might be flat and investors wont be so
lucky. You may look at your 1099 and see the
return on your fund was 0, but you still have to
pay the tax man. Thats when the idea of mutual
funds that are managed for people who pay taxes
will really take off.