The Right Choices Can Reduce Investment Taxes

By on November 24, 2006

Given fluctuations in the market and changing tax law, there’s nothing certain about the amount of taxes individuals will pay annually on their investments, but there are some choices investors can make to reduce their tax bill. Just like fees vary from mutual fund to mutual fund, the taxes that different funds generate also vary – even within the same fund category. Taxes get less attention than fees but can actually impact returns more significantly. For example, the average fee on an actively managed fund cuts approximately 1.4 percent from returns per year (about 1 percent per year on an asset-weighted basis), but taxes can cut an average annual return by more than a third. Fees associated with purchasing investments are evident, but the returns on investments are not. Investors can reduce market variability by diversifying their wealth among asset classes and keep costs low by monitoring fees and employing a “buy-and-hold” strategy to lower taxes. But the fund’s manager may not be following the same “buy-and-hold” practice. In fact, the average turnover for stocks in an actively managed fund is close to 100 percent in a given year. And because fund managers are required to distribute the capital gains to investors each year, that turnover can result in some hefty taxes. Efficient funds that have low turnover and offset gains with losses may not make disbursements, so the investor only pays taxes when selling the fund. But even managers with some turnover can mitigate the amount investors pay in taxes. Equity investments that are held for at least one year qualify for the 15 percent capital gains tax rate as opposed to the 35 percent ordinary income tax rate. But on average, a significant percentage of gains are being taxed at the higher ordinary tax rate – cutting a great deal from returns. Investors should always look at pre- and post-tax return performance before making a taxable investment decision. This data is available on financial research Web sites like Morningstar. com. Investors should also pay particular attention to the times of the year in which they purchase funds – fund managers tend to make distributions close to year’s end.

Leave a Reply

Your email address will not be published.