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Mutual funds have to work off losses before tax kicks in
Published on Monday, Sep 14, 2009
Life is full of perverse surprises.
A candidate for president of the United States runs on the idea that people with more money should pay more taxes. They should, he says, pay higher taxes on capital gains. They should also pay higher taxes on dividends. The new tax revenue would be used to pay for health-care improvements and other government programs.
He wins.
But while the candidate was winning, the world was changing. In particular, the stock market was crashing.
Stocks were losing years of gains. An investor who put $100,000 into the Vanguard 500 Index fund in early 1998, for instance, would have collected thousands of dollars in dividends and paid taxes on same, but his investment would only be worth about $100,000. His cost basis (original investment plus reinvested dividends) would be more than $122,000. So he would have an unrealized loss of $22,000 in the middle of 2009 and he'd consider himself fortunate because he had lost so much less than others he knew.
Indeed, in our new upside-down world, there is a new brag for investors: I lost less than you lost.
So let them raise the tax rate on capital gains and dividends. While our friends in Washington will clip an extra nickel out of each dollar of dividend income, the reality is that they won't get a cent in capital gains tax revenue because most people don't have any gains to realize and pay taxes on.
We can also use that reality to become virtually tax-free investors for the near future.
How?
We can make mutual-fund investments today that will be tax-free for years simply because the fund has
large capital losses on its books. As a consequence, the stock market can rise substantially, but many funds are unlikely to realize and distribute a taxable capital gain until they have worked off their losses.
Let me give you an example. According to the Morningstar mutual-fund database, the average large blend domestic equity fund had losses equal to 48 percent of its assets at the end of June. This means the average fund could gain nearly 10 percent a year for more than four years before it would be likely to distribute a taxable capital gain.
You wouldn't be immune from capital gains since you could sell shares on your own and realize a capital gain at any time, but at least you would not have much chance of having the fund manager realize a capital gain and distribute it to you.
AIM Charter A shares (ticker: CHTRX), for instance, have unrealized capital losses of 73 percent of assets, according to the Morningstar database, in spite of being rated four stars and having performed in the top 10 percent of its peer group in the last one-, three- and five-year periods. Similarly, Thornburg Value A shares (ticker: TVAFX) have unrealized capital losses of 56 percent of assets in spite of a four-star rating and having been a top-decile performer in most time periods out to 10 years.
Are there any fund categories where we can find still larger losses that will raise our chances of having an even longer tax holiday? You bet.
Exploring the Morningstar mutual-fund database, I found that midcap growth funds, as a group, had unrealized losses equaled to 75 percent of their assets. I also found that the average technology fund had virtually no dividend income and had losses equal to a whopping 156 percent of its assets. It would take a major bull market to produce a tax bill there.
The loss figure was 96 percent for the average finance specialized fund and 97 percent for the average real-estate specialized fund. These funds could basically double in value before you would be likely to face a capital gains distribution.
Note that we are not talking about tax deferral. We're talking about investments that will be largely tax-free for quite a few years.
Combine that with wretchedly low yields on fixed-income investments, and you've got a really good reason to favor equities.
Questions about personal finance and investments may be sent by e-mail to scott@scottburns.com. The Web site http://www.scottburns.com has comments on articles, referenced Web links and discussion of personal finance topics on forums. Questions of general interest will be answered in future columns and on the Web site.
Life is full of perverse surprises.
Get the full article here.
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