How to avoid or postpone the tax on capital gains, and the funds that can help you do it. By Andrew Tanzer, Senior Associate Editor October 3, 2008 The nip of autumn is in the air, and that means it's time for many mutual fund companies to announce their capital-gains distributions. This has been a wretched year for the stock market, but because of the way funds work, you may still be on the hook for income taxes next April. Whether the market is up or down, it is a good time to consider the impact of taxes on your funds' returns and to look at funds that care about your tax bill.Big bucks are at stake. The Investment Company Institute, the fund industry trade group, reports that some $6 trillion of fund assets rest in taxable accounts. In 2007, estimates research outfit Lipper, funds distributed a record $150 billion in capital gains, on which investors paid a record $34 billion in taxes. Lipper calculates that the tax take for the average fund in 2007 was 1.7 percentage points, equal to 24% of the gain of the average U.S. stock fund that year. Research shows that over the decades, the hit for taxable investors in actively managed funds has averaged two points, or 20% of the stock market's long-term gains. That leakage exceeds the combined loss to commissions and management fees. The rules for funds and taxes are complicated. Unlike capital gains from stocks, which are triggered and taxed only when you sell the shares, funds are required to pay out to shareholders essentially all earnings realized each year, as well as dividends they have collected from their holdings. Your fund may have lost money this year yet generated taxable distributions because it sold profitable positions. Advertisement Missing from the debate What most discussions of funds and taxes neglect, however, is that distributions lower your future taxes. If you reinvest your distribution, as most investors do, you increase your tax basis, the figure on which you determine gains or losses when you sell your shares later (see The Scoop on Fund Distributions). If you don't reinvest, you will collect less when you sell than you would if there had been no payout. So in comparing tax-efficient funds with funds that pay large distributions, the issue generally isn't one of paying now as opposed to paying never; it's paying now versus paying later. The bite from paying taxes to Uncle Sam on a regular basis is not trivial. Say you have a portfolio of $100,000. If you lose two percentage points a year to taxes and the portfolio compounds at 8%, you will have $126,000 after three years. If the money compounds at 10%, your funds will be worth $133,000, only 5.5% more than what you earned with an 8% annual return. But look at what happens if you let that $100,000 portfolio ride over 30 years, which is less than an investing lifetime: At 8% annualized, the portfolio expands to $1 million, but at 10% annualized, it compounds to $1.75 million, 75% more than if you lost two points to taxes each year. Joel Dickson, of the Vanguard Group, says you should build tax efficiency into your long-term investment plan. After all, unlike stock-market or interest-rate movements, tax efficiency is a relatively controllable part of your investment program. And you should consider carefully whether each investment should reside in a taxable or tax-deferred account. Ponder this long-term investment strategy for the stock portion of your taxable portfolio: Sock away a chunk of your core stock portfolio -- whether it's $10,000 or $500,000 -- in funds that minimize corrosive losses to taxes and hold them for an investing lifetime. Advertisement To understand the potential of such a strategy, consider a lofty ideal: By buying and holding funds that never pay out capital gains, you never pay capital-gains taxes. Under current law, the IRS offers two wonderful tax breaks for investors who master the challenge of compounding but not realizing capital gains over an investing lifetime: stepped-up basis and charitable contributions. Under the step-up rules, the cost of an investor's stocks or funds is stepped up to their market value when he or she dies. Thus, if a $100,000 portfolio grows to $500,000 over time, your heirs' basis is stepped up to $500,000, and the $400,000 of capital appreciation goes completely untaxed. If you donate appreciated funds to charity, you enjoy a double benefit. Say the fund's value has grown from $10,000 to $50,000. You pay no tax on the gains, and you can deduct the full value of the gift ($50,000) on your taxes. The donee receives a $50,000 asset with no capital-gains tax liability. So how do you identify tax-friendly funds in which to park your core stock money? You can do a lot worse than simply investing in passively managed index funds, such as Vanguard Total Stock Market Index (symbol VTSMX) or the exchange-traded iShares S&P 500 Index (IVV). Advertisement There are several advantages to indexing in taxable accounts, some obvious and others more subtle. Turnover in large-company index funds, such as those that track Standard & Poor's 500-stock index, is minimal, so capital-gains distributions are kept to a minimum (by contrast, the average managed fund's annual turnover is nearly 100%). When you combine the extra fees and transaction costs of managed funds with the larger tax bite, active managers need to beat an index by more than 2.5 percentage points a year to justify themselves to a taxable investor, a high hurdle indeed. How hard is it to beat those odds? Rob Arnott, of Research Affiliates, found that over several extended periods of time, 78% to 95% of managed funds failed to beat the indexes before taxes, rising to 86% to 96% after taxes (like all of the pretax and post-tax comparisons in this article, both cases assume funds are held and not liquidated). According to Morningstar, over the ten years through August 31, 2008, 31% of active managers beat Vanguard Total Stock Market Index before tax, but only 23% after tax. But here's the rub: Although beating index funds on an after-tax basis is possible, it's difficult to identify which funds will jump that hurdle in the future. Or say the manager you like has a low-turnover, tax-efficient style. If he or she moves on, the new manager may follow a different philosophy, revamp the portfolio and, as a result, generate large capital-gains distributions (just ask the shareholders of Fidelity Magellan, who were hit with a huge tax bill in 2006 after Harry Lange took the reins). Or maybe you sour on the manager and dump the fund. If you've made a profit, you'll pay federal tax plus, perhaps, state taxes. An alternative is to invest in tax-managed stock funds, which deploy a bunch of devices to minimize capital-gains distributions. For instance, they harvest stock losses (which can be carried forward up to seven years) to offset gains in the portfolio. They sell stock lots with the highest cost basis first to minimize capital gains. They may sit on a winner until 12 months have passed before recognizing a gain (Uncle Sam taxes short-term gains -- those recognized within 12 months of a stock's purchase -- at rates as high as 35%). Some tax-managed funds also tilt portfolios away from dividend-paying stocks in favor of growth stocks that retain earnings instead of distributing them. Advertisement Among no-load funds, Vanguard has the best lineup of tax-managed funds. Index funds are tax-efficient to begin with, but Dickson says that through back-testing tax-management strategies on the S&P 500 index from 1977 through 1993, Vanguard concluded that it could improve after-tax returns through applying some simple techniques, such as those described above. In 1994, Vanguard launched its first two tax-managed funds, which are essentially enhanced versions of its index funds. Vanguard Tax-Managed Capital Appreciation (VMCAX) tracks the Russell 1000 index, and Tax-Managed Growth & Income (VTGIX) is a play on the S&P 500. In 1999 Vanguard added Tax-Managed International (VTMGX), which tracks the MSCI EAFE index of developed overseas markets, and Tax-Managed Small Cap (VTMSX), which mimics the S&P 600 index. The funds require a relatively high minimum investment of $10,000 and levy a 1% penalty on investors who redeem shares in less than five years. Discouraging redemption allows the funds to keep the cash balance as low as possible. That minimizes distribution of interest payments, taxable as ordinary income. Fine after-tax results When you combine Vanguard's low costs -- annual fees are 0.15% on each of the four funds --with skilled tax management (none of the four has ever made a capital-gains distribution), you get fine results. For instance, Capital Appreciation returned an annualized 7.6% before tax and 7.4% after tax over the past five years through August 31, beating 72% of funds in the same category before tax and 82% after tax, according to Morningstar. Similarly, International gained 13.9% a year before and after tax during the same five years, besting 74% of funds before tax and 85% after tax. Fidelity Tax Managed Stock (FTXMX) demonstrates that funds in this category need not be low-turnover or dull. Keith Quinton, who has run the fund since February 2004, describes his tax-managed investment style as "an aggressive shotgun approach." He quickly harvests losses in investments that don't work, which is one reason his fund has a towering annual turnover ratio of 200%. To select stocks, Quinton combines his own quantitative models with research bubbling up from Fidelity's army of analysts. To manage taxes, he says, he's always conscious of the cost basis of every stock he trades and the extent of realized losses. He also doubles up on positions he likes if the stock price falls, waiting 30 days to avoid tax complications before selling the higher-cost lot to generate a loss. Some of his fund's largest holdings recently were IBM, United States Steel and Hess. Quinton's results are impressive. In the past five years through August 31, his fund returned 9.5% a year before tax and 9.4% after tax -- better than 94% of large-company funds. (By comparison, Fidelity Magellan returned an annualized 6.1% before tax and 4.6% after tax during the same stretch.) As with the Vanguard funds, the Fidelity tax-managed fund hasn't distributed a capital gain since its inception in 1998. It also requires a $10,000 minimum investment, and it levies a 1% redemption fee on shares held less than two years. Annual expenses are 0.82%. But a fund's name and charter don't have to mandate tax efficiency for a fund to be productive at delivering attractive after-tax returns for shareholders. Look for fund managers who tend to buy and hold stocks, compounding capital gains instead of perpetually distributing them. You want managers with consistent, long-term records whom you can stick with. Several of the Kiplinger 25 funds match this description. Interestingly, all of them are run by managers who are heavily invested in their own funds, which supports the theory that managers who eat their own cooking are much more likely to be sensitive to the interests of shareholders who invest taxable money. Fairholme (FAIRX), for instance, returned an average of 16.1% before tax and 15.6% after tax in the five years through August 31, good enough to land it in the top 1% of large-company blend funds. Longleaf Partners (LLPFX), Selected American Shares (SLASX) and Vanguard Primecap Core (VPCCX) all have fine long-term records achieved with consistently low portfolio turnover.