NEW YORK -- Mutual fund investors may be pleasantly surprised this month when they open their year-end statements, with capital gains - and in turn the taxes on them - likely to come in at relatively low levels.
Analysts and financial planners say most mutual funds are reporting fewer capital gains - the net profit after a stock is sold for more than its purchase price - because 2003's returns were offset by losses of previous years. Mutual funds, like individual investors, are permitted to carry previous losses forward to avoid being overly taxed on gains.
According to preliminary data gathered by the Investment Company Institute through October, overall capital gains distributions from mutual funds could be 30 percent to 40 percent lower than those reported in 2002, when they dipped to just $16 billion.
That's significantly off the high of $326 billion reported in 2000, when mutual fund investors suffered the double wallop of high tax bills along with negative returns amid serious market losses. Even if a fund lost money for the year, shareholders still had to pay taxes on net profits.
"The stock market itself has not completely recovered from the bear market," said Brian Reid, senior economist with ICI, a Washington-based mutual fund trade group. "Even with a really solid year, mutual funds had sizable embedded losses."
Some sectors were likely to distribute more gains than others this year. Of the funds reporting capital gains, Reid said, a larger than usual proportion was paid out by bond funds, although the amount was still low relative to asset size. In addition, other analysts said funds focused on gold and real estate investment trusts, or REITS, were likely to pass along gains to investors.
It may not matter much to investors who have most of their money in tax-sheltered retirement accounts - estimated at more than half of the $7.2 trillion under management in mutual funds - but this year's lower capital gains could be a bright spot for those with portfolios that are subject to taxes.
Lipper Inc. research analyst Tom Roseen said taxes can be an even bigger drain on returns over the long term than fund management fees. The study by Lipper estimated shareholders in the highest bracket lost up to 25 percent to taxes over the last decade.
"To say it doesn't matter because half are in deferred accounts, that just doesn't wash with me," Roseen said. "Letting the fund families know that taxes are a concern for you might make the portfolio managers a little more conscious about their trades."
There is also some relief from the tax cut signed into law by President Bush last year, which limited taxes on qualified stock dividend payments to a maximum of 15 percent, retroactive to Jan. 1, 2003. Dividends used to be taxed as regular income.
In addition, the tax rate on long-term capital gains - profits made on the sale of stocks held for more than a year - dropped to 15 percent from 20 percent. That change took effect May 5, 2003.
Short-term capital gains, interest payments on bonds and most REITs will continue to be taxed at the highest marginal rate.
To mitigate future tax losses, you might consider investing with one of the more than 40 fund families that offer special tax-managed funds, where portfolio managers use techniques to offset capital gains. Companies that offer such funds include T. Rowe Price, Vanguard Group, Fidelity, American Century and Eaton Vance.
Index funds are another good bet; they tend to have lower portfolio turnover ratios, meaning they're likely to have fewer short-term capital gains. A tax-efficient alternative to mutual funds are exchange-traded funds, or ETFs, which track indexes but trade like stocks.
Given the changes in the tax laws, you might be inclined to adjust the allocations in your retirement account so it includes the funds that are taxed at the highest rate, said Jack Piazza of Sensible Investment Strategies in Wheaton, Ill.
"In general, if they had their choice where to keep bond funds or real estate investment trusts, they'd probably be best served to use their retirement plan," Piazza said. "That way the distributions can compound on a tax deferred basis."
Still, Piazza and other experts said an investor should never make decisions based only on tax efficiency. More important by far are the quality of your investments and the overall allocation within your portfolio, your time horizon and tolerance for risk.
"Never look at tax ratings without also looking at performance," said Roseen, of Lipper. "A very poor performing fund that pays out no capital gains and issues no distribution is certainly tax efficient."
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