Alpha Teach Yourself Investing in 24 Hours: An Analysis (part 45)

Picking a Mutual Fund (part B)

by

Charles Lamson

Taxes

Taxes are a nasty subject, but an important one for mutual fund managers. Along with other fees and expenses, taxes affect the total return of your fund.

As a shareholder of a mutual fund, taxes are passed through to you, as well as dividends. These distributions usually occur in December, but check the prospectus of your fund for details.

A capital gain occurs when the fund sells a stock it is holding for a profit. That profit is distributed to you in cash, or it can be reinvested back into the fund. Even if it is reinvested, you still are liable for tax on the gain.

If the fund held the stock for more than a year, the profit is considered a long-term capital gain and is taxed at 20 percent. However, if the fund held the stock for less than a year before selling, the gain is treated as ordinary income and subject to tax at your personal income tax bracket.

The distribution may also be subject to state and local taxes. If a fund is not tax-efficient, you will be giving up a big chunk of the gains to taxes. Funds are reluctant to quote returns on an after-tax basis, so it is up to you to avoid funds that create big tax events each year.

Many of the online services will give you a tax-efficiency rating to help you identify known tax offenders.

JUST A MINUTE After-tax returns are more important than pre-tax returns because they give you a truer picture of your actual return. Few mutual fund companies report their funds on an after-tax basis.

               

Index fund supporters point out, quite correctly, that they are the most tax-efficient of all mutual funds. The reason is that index funds seldom buy or sell funds, thus there are fewer gains to distribute. By the way, index funds only trade when stocks that make up the index are bought or merge or are replaced by the index originators.

Of course, many of the unpleasant tax consequences are avoided or at least postponed by containing your funds that generate gains in retirement accounts. Most of us will have to do more than just a 401 (k) or IRA to fund our retirement, so part of our retirement portfolio will have to be outside of a tax-deferred home. This makes it even more important than ever to be careful of tax consequences.

The biggest fundamental in picking a mutual fund is looking for low expenses. Big returns do not mean much if you give most of that money back in loads, funds, taxes, and so on. Always compare funds of comparable makeup. Remember to compare apples to apples. The Internet is a goldmine of easy-to-access information.

*SOURCE: ALPHA TEACH YOURSELF INVESTING IN 24 HOURS, 2000, KEN LITTLE, PGS. 260-261*

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JUST A MINUTE

After-tax returns are more important than pre-tax returns because they give you a truer picture of your actual return. Few mutual fund companies report their funds on an after-tax basis.