Tax-Smart Investing. Part 2

Sometimes the tax trail seems like a bad dream. First, you pay taxes on the money you earn. If you put your remaining funds in the bank, you pay taxes on the interest. If you put the money in stocks, your shares represent partial ownership of companies that pay taxes on their corporate income. Nevertheless, you pay additional taxes on the dividends you receive and on any capital gains you are lucky enough to realize.

Things only get worse when you invest in mutual funds. When you buy shares in a mutual fund, you inherit the purchase history of the stocks or bonds held by the fund. For example, Fidelity Magellan has bought shares of General Electric at different times and at various prices over the years. Each purchase established a cost basis for shares bought on that date. Since General Electric stock has done well, the average cost basis is much lower than its current market value. This is referred to as an embedded capital gain. When an unsuspecting fund investor buys share in the Magellan fund, she inherits the tax liability associated with this embedded gain. Any time Magellan sells some shares of General Electric, a realized capital gain occurs that is taxed by the federal government. This tax charge is deducted from each investor's account when the fund declares its annual capital gains distribution. The innocent new investor ends up paying taxes on embedded gains that have been building up for years.

Even more galling is that you typically pay capital gains distributions even when your fund loses money. Last year, U.S. stock mutual funds reported $345 billion in taxable capital gains distributions, yet the average fund was down 4.5%. To add insult to injury, any profits you make when you sell your mutual fund shares are subject to additional capital gains taxes.

Is there any remedy for this unrelenting tax nightmare? One approach is to invest in individual stocks. Although this strategy has its own tax issues (discussed in last month's newsletter), it gives you more control over your tax liabilities. The best strategy for mutual fund investors is to focus on index funds and tax-managed funds. Index funds use a buy-and-hold approach resulting in lower portfolio turnover. This helps keep the taxable distributions in check, although it does not eliminate them. Tax-managed funds minimize capital gains distributions via tax-efficient trading strategies. These funds should be used for your taxable investment accounts, while straight index funds are more suitable for your tax-deferred accounts.

It has been said that the only sure things in life are death and taxes. Although neither one can be avoided, there's nothing wrong with forestalling the former and minimizing the latter. As we noted last month, tax-efficient financial management is almost guaranteed to put more money in your pocket.

June 1, 2001

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