If you immediately sold the fund, the whole thing would be a wash, as the capital gains would be offset by a capital loss. The distribution lowers the NAV, so the amount of taxes you would pay would be lower than if you sold the fund years from now. Still, most investors would rather pay taxes later than sooner. And we're guessing that if you just invested in the fund, you weren't planning to turn around and sell it right away.
Funds occasionally can add insult to injury by paying out a large capital-gains distribution in a year in which the fund lost money. In other words, you can lose money in a fund and still have to pay taxes. In 2000, for example, many technology funds made big capital-gains distributions, even though almost all of them were in the red for the year. Although the funds lost money during the year, they sold some stocks bought at lower prices and had to pay out capital-gains as a result. Technology-fund investors lost money to both the market and Uncle Sam that year.
Alleviate tax headaches by following these tips:
- Tip 1. Ask a fund company if a distribution is imminent before buying a fund, especially if you are investing late in the calendar year. (Funds often make capital-gains distributions in December.) Find out if the fund has tax-loss carry-forwards -- that is, if it has booked capital losses in previous years that can be used to offset capital gains in future years. That means the fund could be tax-friendly in the future.
- Tip 2. Place tax-inefficient funds in tax-deferred accounts, such as IRAs or 401k's. If a fund has a turnover rate of 100% or more, it's a good indication that limiting the tax collector's cut isn't one of the manager's objectives.
- Tip 3. Search for extremely low-turnover funds -- in other words, funds in which the manager isn't doing a lot of buying and selling and therefore isn't realizing a lot of taxable capital gains. A fund with a turnover rate of 50% isn't four times more tax-efficient than a fund with a 200% turnover rate. But funds with turnover rates below 10% tend to be tax-efficient. You can find turnover rates on Morningstar, as well as in your fund's annual report.
- Tip 4. Favor funds run by managers who have their own wealth invested in their funds, such as Marty Whitman of Third Avenue Value (TAVFX)or the managers of Tweedy, Browne Global Value (TBGVX). These managers are likely to be tax conscious because at least some of the money they have invested in their funds is in taxable accounts. The Securities and Exchange Commission will soon require fund families to disclose whether their managers have a stake in the funds they manage and, if so, how much.
- Tip 5. If you want to buy a bond fund and are in a higher tax bracket, consider municipal-bond funds. Income from these funds is usually tax-exempt.
- Tip 6. Consider tax-managed funds. These funds use a series of strategies to limit their taxable distributions. Vanguard, Fidelity and T. Rowe Price all offer tax-managed funds.
Even when you follow these tips, it can be difficult to find a fund that's consistently tax-efficient. But don't get so caught up in tax considerations that you overlook good performance. After all, a tax-efficient fund that returns 7% after taxes is no match for a tax-inefficient fund that nets 15% after Uncle Sam takes his share. (You can find after-tax returns in our Fund Reports on Morningstar.com.) In the end, it is what you keep, not what you give away, that counts.
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