By CHET CURRIER= ^AP Business Writer=
SAN DIEGO (AP) Many people have tried, but nobody has had much success in solving a troublesome puzzle posed by taxes on stock mutual funds.
The problem is what to do about those pesky capital gains distributions that funds must make to their investors every year on net profits from portfolio investments.
As many fund investors now doing their income tax returns can testify, these distributions come in unpredictable amounts that can scramble the best-laid plans.
Quite a few fund families have responded to the situation by organizing "tax-efficient" funds that seek to minimize taxable distributions each year. But as one student of the subject told a recent audience of financial and investment planners in San Diego, even those funds can't get around an obstacle that is built into the system.
"The tax law doesn't allow that," said Mark Hurley, president of Undiscovered Managers, a Dallas fund management firm, at the annual conference of planners sponsored by Waterhouse Securities.
If you invest directly in stocks, you usually control when you realize profits that incur a capital gains tax. As long as you don't sell a winning investment, you postpone the day of reckoning with Uncle Sam and keep all your money at work compounding for you.
When you invest in a fund instead, your give up some of that control. To stay exempt from paying taxes themselves, funds are required to pass the taxable gains they realize through to investors.
Figuring from estimates by the Investment Company Institute trade association, roughly $80 billion in long-term capital gains was paid to taxable investors in 1998, on top of more than $90 billion the year before. Even at the maximum capital-gains tax rate of 20 percent, that's a lot of taxable income.
Experienced investors know that whatever distributions they are hit with now reduce their potential future tax liability. In that sense, it all balances out eventually.
But the more you can postpone taxes, the greater the amount you can keep working for you until it's time to pay up. "Investors must eventually pay taxes on all their capital gains," said Hurley. "The whole key is when you pay them."
One popular answer to this problem is to pick funds with low portfolio turnover, on the reasoning that these funds will cash in fewer gains each year. Low turnover is a basic part of the strategy employed at most "tax-efficient" funds.
Think for a moment, though, about what happens in a fund where few or no gains are realized over several years of a strong bull market. The fund builds up a large backlog of gains that would necessitate big taxable distributions when the investments in question are eventually sold.
So a fund that has a very good past record of tax efficiency may be one of the worst choices tax-conscious investors coulmake to buy today.
"The tax efficiency of a mutual fund is not static," Hurley points out. "Each mutual fund has a tax life cycle that substantially benefits some shareholders and disadvantages others."
What to do about all this? As complicated as the problem may be, it leaves room for some simple solutions. Above all, it needs to be kept in perspective.
You can dodge the whole issue of taxable distributions entirely if you invest through a tax-deferred savings vehicle such as an individual retirement account or employer-sponsored 401(k) plan. In these accounts, no tax is levied until you take withdrawals.
As for your taxable fund investments, once you have a field of good funds to choose among, you can aim to minimize your tax headaches by looking for funds that have few embedded gains they might realize soon. Example: A new fund run by an established manager. Or a newly organized index fund, rather than one in the same family that has been operating for years.
Always remember, Hurley added, "if you don't have good pretax returns you will never have good aftertax returns." In other words, if you focus too much on taxes without making a good fundamental investment choice in the first place, you may wind up having few gains to worry about.
(Copyright 1999 by The Associated Press. All Rights Reserved.)