Mutual Fund Tax Tips

With Uncle Sam waiting impatiently for April 17 (the filing deadline for tax year 2005), now is the time for all good investors to consider the implications of owning mutual funds. And that's true not just for this tax season, but for those of future years as well.

Indeed, it's never too early to get a jump start on tax planning, and with that in mind, here are three points for savvy fund investors to ponder.

1. Favor low turnover funds.
If your fund generates capital gains during a given year, it has to distribute those gains -- less the losses the fund incurred, including any "tax-loss carry forwards" the manager has, so to speak, saved up.

So far, so good. But alas, even though you didn't trigger the sales that led to the gains, you're still liable for taxes on them if you're invested through a taxable account. You might not have asked for it -- goes the IRS's thinking -- but the fund company still cut you a check for your slice of the distribution pie. And Uncle Sam wants his slice of that slice.

Ergo, you should generally favor low-turnover funds, since it's the selling of securities that racks up taxable capital gains. Vanguard's 500 Index (FUND: VFINX  ) and Total Stock Market (FUND: VTSMX  ) funds -- passively managed stalwarts that both count the likes of Microsoft (Nasdaq: MSFT  ) , Intel (Nasdaq: INTC  ) , and Amgen (Nasdaq: AMGN  ) among their holdings -- sported turnover rates last year of just 7% and 16%, respectively. Not surprisingly, they've been highly tax-efficient over the long haul.

Plenty of actively managed funds have done a good job of keeping the taxman at bay, too. For example, T. Rowe Price Blue Chip Growth (TRBLX) -- a fund whose year-end holdings list included Google (Nasdaq: GOOG  ) and Yahoo (Nasdaq: YHOO  ) -- ranks among the most tax-efficient in its Morningstar large-growth peer group. On an annualized basis, Morningstar estimates that this fund has given back just 27 basis points of its pretax gains to Uncle Sam for the 10 years that ended with February.

Not too shabby, eh?

2. Reinvest your distributions.
Readers of Motley Fool Champion Funds -- the Fool newsletter service that I head up -- know that I'm a big fan of reinvesting distributions. After all, if you've done the due diligence and zeroed in on funds with top-notch management teams, sound investing strategies, low price tags, and solid track records of success -- the newsletter's core criteria -- why not put the payout to work by purchasing additional shares?

Fund companies are only too happy to set up this feature for you automatically, and if you're not already doing so, I urge you to consider taking advantage of it. Yes, you'll still have to pay taxes on the distribution, but your reinvestment will help grow the size of your portfolio and -- thanks to the miracle of compound interest -- a bigger pie can mean bigger after-tax gains.

3. Don't obsess over tax efficiency.
Notice that above I said favor low turnover funds. As important as tax efficiency is, don't let it be the tail that wags the proverbial dog. All else being equal, I'll take a fatter return over greater tax efficiency any day of the week.

What's more, while I may want to hold the fund in a tax-favored account such as an IRA, if the manager has notched his peer- and benchmark-besting track record with a relatively high turnover strategy, so be it. This isn't a beauty contest.

The Foolish bottom line
That said, I do think the funds we've uncovered so far in Champion Funds are beauties -- and the average turnover rate of the picks we've made falls well below the industry average. Not coincidentally, our recommendations have spanked the market's return since we opened for business back in March 2004. As I type, we're beating the market by a margin of 22.21% to 11.13%.

If you'd like to take a look at our recommendations list -- along with our back issues, model portfolios, and members-only discussion boards -- a 30-day guest pass is available now. Click here to get started. I suspect that your tax preparer (which I'm guessing just might be you) will be glad you did.

Shannon Zimmerman runs point on the Fool's Champion Funds newsletter service and owns shares of Vanguard Total Stock Market. Microsoft and Intel are Motley Fool Inside Value picks. The Fool is investors writing for investors, and you can read all about our disclosure policy by clicking right here.


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