5 Ways to Beat the Tax Bite of Mutual Funds

By Ron DeLegge, Editor

November 4, 2008

SAN DIEGO (ETFguide.com) – A bad year for mutual fund investors is about to get worse. That’s because buy-and-hold investors with funds held in taxable accounts are about to get slammed with an unexpected surprise: A big fat tax bill.

November and December are when most fund companies distribute their year-end capital gains. And even though most U.S. and international stock funds have declined substantially in value, many will still end up distributing significant capital gains to unsuspecting shareholders.

How is it possible to have tax gains when my funds have lost value?

Massive fund redemptions by panicked investors have forced portfolio managers to sell stocks in order to pay off exiting shareholders. Most of the paid out capital gains will be from stocks purchased by fund managers in previous years.

How big will the 2008 tax bite be?

If history is any guide, the estimated tax bite will be somewhere between $30 to $50 billion.

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According to fund tracker Lipper, buy-and-hold mutual fund investors forfeited a staggering $33.8 billion in 2007 alone. It’s an almost sure bet that 2008’s tax bite will surpass last year’s very large number. And while the exact answer of tax distributions will vary fund to fund, don’t be surprised to see tax gain distributions of 20 or 30 percent of your fund’s net asset value (NAV).

Taxes are a frequently overlooked aspect of successful investing. Many investors make the mistake of buying mutual funds with great historical performance and instead they wind up buying themselves a hidden tax bill.  

What can you do to limit your financial damage?

Take Immediate Action!

Check with you mutual fund company to see if the funds you own are planning to make any capital gain distributions. Some fund companies have already published estimated tax gain distributions along with the dates they’ll be paid.

If you own any underperforming mutual funds, now is probably a good time to consider selling them before they stick you with a hefty tax distribution.The key is to be aggressive and to take the immediate action to lower your tax liabilities as much as possible.

Delay Your Fund Purchases

One of the most common errors made by fund investors is making an investment in a fund just before it makes a sizeable year-end tax distribution. This mistake most frequently occurs with investors that use an auto-pilot plan of dollar-cost-averaging into their mutual fund investments.

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Are you making regular investments into your taxable mutual fund account? If you are, then it’s probably a good idea to delay the purchase of new shares until after your fund’s tax distribution record date. An even smarter strategy is to start putting money into funds that don’t hit you with tax surprises in the first place!

Use the Right Financial Products

Using the wrong financial products to accomplish your goals will slow your progress. What good are mutual funds that soak you with an unexpected tax bill? In contrast, owning index ETFs can help you to avoid not just the underperformance of actively managed mutual funds but the threat of higher taxes.

Established ETFs like Vanguard’s Total Stock Market ETF (NYSEArca: VTI), the SPDRs (AMEX: SPY), and the DIAMONDS Trust (AMEX: DIA) have all done an excellent job of limiting annual capital gain distributions. (See ETFguide.com’s Profit Strategies Newsletter to help you choose other tax smart ETFs.)  

Location, location, location!

In real estate, it’s commonly said that location is the single most important factor. It’s the same when it comes to positioning your money or assets.  

Coordinating your investments so as to hold tax inefficient asset classes like bonds (NYSEArca: AGG) commodities (NYSEArca: GSG) and real estate investment trusts (NYSEArca: VNQ) in tax-deferred accounts can save you a bundle. Alternatively, holding tax efficient asset classes like equities in your taxable investment account makes good sense. 

Talk to Your Investment Advisor

If you bought your mutual funds at the recommendation of an investment advisor, ask them what type of tax liabilities the funds they sold you will have on your bottom line. Are your mutual funds going to increase your 2008 tax liabilities or decrease them? You don’t need complicated answers; just a “yes” or “no” will suffice.

If your advisor is unwilling to answer your tax questions or if you’re not getting the response you’re looking for, start searching for a new advisor. Financial advisors that recommend index funds or index exchange-traded funds (ETFs) are a good place to start. (See the free referral service at IndexShow.com)

Conclusion

Ignoring the tax ramifications of your mutual fund investments is like ignoring the symptoms of a life-threatening disease. Pretending everything is OK, will not help you to get better.

The greatest victims of 2008’s tax distribution tsunami will be mutual fund investors with their heads buried in the sand.

Don’t be one of them.