Everybody hates taxes. But for some reason, most mutual fund investors continue to carelessly pay taxes they could easily avoid.
Surprising as that is, it's the inescapable conclusion of a study released by Lipper, the fund-tracking company. In fact, the typical investor gives up about one-fourth of his or her profits to taxes, Lipper says.
While experts have long recognized this problem, Lipper has produced some fresh numbers. During the past decade, stock-fund investors in the top income-tax bracket gave up an average of 2.5 percent of their assets to capital gains and income taxes each year, while bond-fund investors gave up 1.3 percent. The bite is smaller for people in lower tax brackets, but taxes can corrode long-term gains for anyone.
It's likely that most investors don't think about this cost. But even those who did could easily dismiss it in the 1990s, when funds were scoring annual gains of 10 percent, 15 percent or 20 percent.
But if annual returns fall into the 5 percent, 6 percent or 7 percent range over the next few years, as many experts expect, tax costs could severely undermine the long-term compounding that investors expect.
Imagine you had a fund that returned 7 percent before taxes were paid but only 5.5 percent afterward. After 20 years, a $10,000 investment would grow to $29,200 - $9,500 less than if you'd avoided that seemingly insignificant 1.5 percent tax bite.
To avoid the tax, investors should use tax-deferred accounts, such as IRAs and 401(k)s, for funds that would trigger large tax bills if held in ordinary taxable accounts. This includes bond funds that pay a lot of interest, or stock funds that pay a lot through dividends and capital gains distributions.
Taxable accounts should be used for "tax-efficient" funds, such as index funds or ones managed to minimize taxes.
"Considering the substantial amount of return that tax-efficient funds can preserve, investors have thus far shown surprisingly little appetite for tax-efficient alternatives, possibly because information on tax impact has been sparse," Lipper said. About $2.9 trillion, or nearly half of all fund assets, is currently in taxable accounts, Lipper said.
Tax-managed funds, which are designed to be tax-efficient, hold only 1.2 percent of all fund assets in taxable accounts, Lipper said. Index funds and tax-exempt municipal bond funds, both of which also are tax-efficient, make up another 24.5 percent. That leaves about three-quarters of taxable-account assets tied up in funds that aren't tax-efficient.
Annual taxes are triggered by interest and dividend payments and net profits realized on stocks, bonds or other holdings the fund manager sold during the year. By law, these gains must be paid to fund shareholders during the year. In a taxable account, they are taxed even if the investor has the money reinvested in more shares. In 2000, U.S. funds paid out $412.8 billion in income and capital gains, forcing investors to pay an estimated $31.3 billion in taxes, Lipper said.
Tax-managed funds use techniques such as offsetting realized gains with losses or minimizing gains by selling only those holdings subject to the long-term capital gains rate, which is lower than the short-term rate.
Index funds automatically minimize taxes because of their buy-and-hold style. They simply buy the stocks in an index such as the Standard & Poor's 500. Since they don't change their holdings often, they don't realize the gains that trigger taxes.
How do you find tax-efficient funds?
The best source is the other fund-tracking company, Morningstar Inc. Go to its Web site, www.morningstar.com, register and look up the fund that interests you, by either ticker symbol or name. In the left-hand column, press the "tax analysis" button. You'll see how much return has been sacrificed to taxes. Morningstar's Premium Fund Selector can be set to seek tax-efficient funds.
By the way, high management fees do similar damage. The site also can be used to identify low-fee funds.
Not a Web surfer? You can order the company's $19.95 Morningstar 500 guide by calling 800-735-0700.