Tax man cometh after mutual fund investors

APR 25, 2010
Higher federal taxes, coupled with a rising stock market, threaten to hit U.S. fund shareholders particularly hard. Indeed, the average “tax drag” on a stock fund — that is, the tax liability that gets passed on to investors each year — climbed to 0.61% last year, from 0.57% in 2008, according to a study that will be released this week by Lipper Inc. While the tax drag remains low by historical standards, it is likely to continue to escalate over the next several years, said Tom Roseen, a research manager at Lipper Inc. That's because the tax rate on long-term capital gains for households earning more than $250,000 will rise to 20% at the end of the year, from 15%. Add the looming 3.8% flat tax on investment income for high earners, and many investors will see their tax rate jump to 23.8%, Mr. Roseen said. The flat tax, which lawmakers imposed to help pay for health care reform, is scheduled to take effect in 2013. “This is a really big issue,” he said. Unlike most corporations, a mutual fund typically distributes all its earnings — capital gains and ordinary dividends — to shareholders each year. This means that fund investors are responsible for paying tax on a fund's earnings whether they take distributions in cash or reinvest them in the fund. The unwelcome tax news is likely to benefit tax-managed funds that aim to limit their exposure to capital gains distributions. Offered by a small group of firms — Eaton Vance Corp., Fidelity Investments, J.P. Morgan Funds, T. Rowe Price Group Inc. and The Vanguard Group Inc. — the funds haven't been in great demand recently, because of low taxable distributions. But with capital gains once again likely to become an issue, providers of such funds think that financial advisers and their clients may be more receptive to their products. “We're starting to talk more and more with advisers about the unnecessary performance drag of taxes,” said Duncan Richardson, executive vice president and chief equity investment officer at Eaton Vance, which offers 21 tax-managed funds. It is certainly a topic that is beginning to resonate more with investors, said Greg Kurek, a fixed-income specialist at J.P. Morgan Funds, an affiliate of JPMorgan Chase & Co. Investors are slowly beginning to realize that the “easy money” has been made in fixed income, he said. As a result, investors are beginning to look more carefully at equity funds, and because rising taxes are an issue, tax-managed equity funds should benefit, said Mr. Kurek, whose firm offers the $278.9 billion JPMorgan Tax Aware Disciplined Equity Fund (JPDEX).

GREATER RELEVANCE

“I think tax efficiency is going to be important,” he said. This will be especially true for baby boomers who will soon retire and are looking to live off their investments, said Jim Lowell, a partner and chief investment strategist of Adviser Investment Management Inc., which manages more than $1 billion in assets. As a result, “the whole theme of tax management is more relevant to a greater number of investors — maybe an entire generation of investors — than ever before,” he said. That said, tax-managed funds may not be the best answer to their needs, said Mr. Lowell, who is also co-founder and chairman of The Rankings Service, a firm that analyzes fund managers. “I don't like them,” he said. “They tend to be gimmicky.” Micah Porter, president of Minerva Planning Group, disagrees. “They can work,” said Mr. Porter, whose firm has $60 million under management. “I wouldn't view it as a marketing gimmick,” he said. “A marketing gimmick is something with no substance behind it; this serves a purpose.” So how does an investor find the most tax-efficient funds? Lipper and Morningstar Inc. offer investors tools that can be used to measure tax efficiency. Within the Lipper Leader Rating System, a Lipper Leader for tax efficiency is a fund that has been successful at postponing taxes over the measurement period relative to similar funds. The Morningstar Tax Cost Ratio, meanwhile, helps investors better gauge a fund's tax efficiency. The tax cost ratio compares a fund's load-adjusted pretax return with its tax-adjusted return. The resulting number represents the percentage of an investor's assets that are lost to taxes.

Latest News

Northern Trust names new West Region president for wealth
Northern Trust names new West Region president for wealth

The new regional leader brings nearly 25 years of experience as the firm seeks to tap a complex and evolving market.

Capital Group extends retirement plan services further with a focus on advisors
Capital Group extends retirement plan services further with a focus on advisors

The latest updates to its recordkeeping platform, including a solution originally developed for one large 20,000-advisor client, take aim at the small to medium-sized business space.

Why RIAs are the next growth frontier for annuities
Why RIAs are the next growth frontier for annuities

David Lau, founder and CEO of DPL Financial Partners, explains how the RIA boom and product innovation has fueled a slow-burn growth story in annuities.

Supreme Court slaps down challenge to IRS summons for Coinbase user data
Supreme Court slaps down challenge to IRS summons for Coinbase user data

Crypto investor argues the federal agency's probe, upheld by a federal appeals court, would "strip millions of Americans of meaningful privacy protections."

Houston-based RIA Americana Partners adds $1B+ with former Morgan Stanley director
Houston-based RIA Americana Partners adds $1B+ with former Morgan Stanley director

Meanwhile in Chicago, the wirehouse also lost another $454 million team as a group of defectors moved to Wells Fargo.

SPONSORED How advisors can build for high-net-worth complexity

Orion's Tom Wilson on delivering coordinated, high-touch service in a world where returns alone no longer set you apart.

SPONSORED RILAs bring stability, growth during volatile markets

Barely a decade old, registered index-linked annuities have quickly surged in popularity, thanks to their unique blend of protection and growth potential—an appealing option for investors looking to chart a steadier course through today's choppy market waters, says Myles Lambert, Brighthouse Financial.