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New Tax Disclosures for Funds

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By Roy Lewis
October 11, 2002

One of the major drawbacks to investing in mutual funds is the tax hit you can't control. The mutual fund manager determines when the fund will sell its appreciated stock and is then required to pass those resulting gains (some short-term, some long-term) back to you in the form of taxable distributions. And many of these distributions come at a time when the actual value of the fund is declining. Ouch. To make matters worse, many of you reinvest your mutual fund dividends back into more shares in the fund, leaving you with substantial taxable gains but no cash with which to pay the taxes. Double ouch.

The problem has always been trying to find out how tax-efficient your mutual fund might be. While you could obtain that information before you invested, it wasn't easy. This is important information to have, since some funds are more tax-efficient than others.

Don't underestimate the impact of taxes on your mutual fund. In studies cited by the Securities and Exchange Commission (SEC), more than 2.5% of the average stock fund's return is lost each year to taxes. The SEC also reported that between 1994 and 1999, investors in diversified U.S. stock funds surrendered an estimated average of 15% of their annual gains to taxes. Triple ouch.

The truth of the matter is that the only rate of return that really matters is the after-tax rate of return -- and the SEC has moved to make that information available. The SEC now requires mutual fund companies to disclose both before and after-tax rate of return information in their sales literature.

The new SEC reporting rules
The new rules require the mutual fund companies to disclose, in their prospectuses and fund profiles, after-tax rates of return for the preceding...

  • One-year period,
  • Five-year period (or the life of the fund, if shorter), and
  • 10-year period (or the life of the fund, if shorter).

This after-tax information must be presented for both of the following situations:

Keep the shares: This after-tax information assumes that you still hold the fund shares at the end of each applicable period (one-year, five-year, and 10-year). In this case, the pre-tax rate of return is reduced by the federal income taxes imposed by the fund's ordinary and capital gain distributions during the applicable period.

Sell the shares: This after-tax information assumes that you sold the fund shares at the end of each applicable period. In this case, the pre-tax rate of return is reduced by:

  1. The federal income taxes imposed by the fund's ordinary and capital gain distributions during the applicable period; and
  2. The federal income taxes imposed by selling the shares for a gain at the end of the applicable period. If shares are sold for a loss, the resulting tax benefit from that loss is added back to the after-tax return computations.

Calculations and assumptions
When dealing with taxes, there are a number of variables. Your tax rate might not be the same as mine. So how can we each compare the tax performance of this mutual fund? In essence, you can't. But that's not what the SEC was trying to accomplish. The SEC simply wanted all mutual fund summaries to be standardized, so at least you could compare one to another. In order to accomplish that standardization, the SEC placed guidelines on the computations and reporting. They include:

One-year gains: When you're reviewing the "sell the shares" computations, the sales computations for the one-year period are considered to be short-term rather than long-term, and are therefore computed using ordinary tax rates.

Tax rates: In computing after-tax returns, ordinary income and short-term capital gains tax rates are assumed to be the maximum applicable federal rate (currently 38.6%). Long-term capital gain distributions and long-term gains from selling shares are assumed to be at the maximum applicable federal rate (currently 20%).

State and local taxes: For the purposes of these computations, state and local taxes are ignored.

Fees: Rate of return information must be net of any fees and charges imposed by the fund (including load and redemption fees).

Standardized presentation: The SEC requires mutual fund companies to present the return information covered by these rules in a standardized format so that they all look similar, regardless of what fund you might be researching.

What this means to you
Quite simply, you now have an easy way to compare the tax efficiency of different funds. What good is a fund with a reported 20% return if a substantial amount of that return is eaten up in taxes? Not very. And now you'll be able to see, in black and white, how fund assets are handled from a tax standpoint. (Of course, if your mutual funds are in a tax-friendly IRA, then a fund's tax-efficiency is of no concern to you.)

As you already know, it's not what you make that counts, it's what you keep. And forcing the mutual fund companies to provide this after-tax return information will help you determine how much of your mutual fund returns you can keep after Uncle Sam takes his share. If you'd like to read more about these rules, check out the full text of the rules at the SEC website

Roy Lewis understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns. And with the new reporting rules, he might even be interested in buying a mutual fund or two in the future.

This forum and the information provided here should not be relied on as a substitute for independent research to original sources of authority. The Motley Fool does not render legal, accounting, tax, or other professional advice. If legal, tax, or other expert assistance is required, the services of a competent professional should be sought. In other words, if you get audited, don't blame us.