BOSTON - A surge of cash flow into a business can make it seem like a powerhouse. Yet its bottom line might be underwhelming after taxes and other expenses are figured in.
The same can hold true with investing. Enthusiasm about market-beating performance touted in a quarterly mutual-fund report can wither once an investor's after-tax return is calculated.
The gap between pre- and post-tax returns isn't an issue for mutual funds held in retirement accounts such as IRAs or 401(k)s, where investment earnings can grow tax-free. But the difference can be significant for funds held outside a tax-sheltered account, especially for an investor in a high tax bracket.
It's an especially timely consideration as the year draws to a close. In November and December, investors with taxable accounts should stay alert to disclosures about any capital gains distributions that mutual funds expect to make to their investors. A distribution may sound like a gift, but it's not -- it's a gain that Uncle Sam considers taxable income. Still, investors can limit their tax exposure with savvy end-of-year moves.
Investors can take some comfort in the stock market's lousy 2011 performance. The nearly 6 percent decline of the Standard & Poor's 500 index won't help investors meet long-term savings goals. But it does mean that relatively few stock funds have capital gains to pass on to investors. Foreign stocks have fared worse, so investors are even less likely to see tax bills from the international portion of their fund portfolios.
Diversified bond funds have returned an average of 2 percent this year, according to Morningstar. That makes taxable bonds -- a category that excludes municipal bonds, whose investors are exempt from federal taxes -- a logical place to begin when scrutinizing a fund portfolio for potential hidden tax hits.
But don't ignore the stock component. Dividend-paying stocks have generally fared better than the broader market, making them potential candidates to pass on capital gains. And stocks have been unusually volatile this year, which creates an opportunity for fund managers who frequently trade holdings in hopes of beating the market. If they succeed, an investor can get ahead. But the advantage could be minimal if an investor gets hit with capital gains. Here are tips and current considerations to make about mutual funds and limiting tax exposure:
Understand capital gains. When fund managers sell stocks or bonds that appreciated in value, they pass on the capital gains to investors each year. It can happen even if a mutual fund lost money. That's because it's the appreciation of the fund's individual holdings, rather than of the fund as a whole, that trigger capital gains.
Check the estimates. Fund companies are now giving investors a heads-up about which mutual funds they expect will generate short-term capital gains by the end of December.
Consider timing. If a fund expects to distribute a gain, wait until after the distribution date to invest any new cash in that fund, if it will be held in a taxable account.
Consider taking tax losses. To offset capital gains elsewhere in a portfolio, investors might want to consider selling some investments in their taxable accounts that have lost value.
by Mark Jewell Associated Press Nov. 27, 2011 12:00 AM
After-tax return could alter look of investment
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