It's big news, folks, a victory for the individual investor. Effective April 16, the Securities and Exchange Commission (SEC) will require mutual funds to report their returns on an after-tax basis. It's vital information for would-be mutual fund investors, since taxes shave an estimated 2.5 percentage points off the average mutual fund's annual return, if it is held in a taxable account. It also affects the Rule Breaker Portfolio, since we have followed the practice of mutual funds, reporting our returns before taxes.

Today that changes.

How taxes work in mutual funds
Those of you invested in mutual funds know the drill. Every year, the fund sends a statement that details your share of the interest, dividends, and -- this is the crusher -- capital gains that the fund has generated over the past year. If you hold the fund in a tax-advantaged account, like a 401(k) or an individual retirement account (IRA), the information doesn't mean much to you, since you won't pay any taxes on it until retirement.

If you hold a mutual fund in a taxable account, however -- and that was about $2.1 trillion of the $4.6 trillion in non-money market mutual funds in 1999 -- these gains are important. They get added to your annual income taxes. That seems only fair for dividends and interest, since they are income that you received, usually in the form of reinvested shares of the fund.

Capital gains are another story. These occur when the fund sells shares of a stock that have appreciated in value. They don't add income to the fund. They represent the conversion of unrealized paper gains into realized cash. Trouble is, that realization of gains is a taxable event. As a mutual fund shareholder, you are responsible for a share of those gains. The short-term gains are taxed at your regular income tax rate, long-term gains at 20% (10% for those in the lowest tax bracket).

Say you have 10 shares of a fund in a taxable account at $100 per share. You've got $1,000 invested in the fund. The fund converted $5 per share worth of paper gains to realized gains last year. It distributes $50 in capital gains to you, lowering the value of your shares to $950. It then reinvests the $50 in new shares. The result is that you have 10.53 shares worth $95 each, a total value of $1,000. You've broken even, but you have to pay taxes this year on that $50 distribution.

The reason for the SEC rule
Capital gains are a necessary evil in mutual funds, since they have to move money in and out of the fund. (Bill Mann wrote a fine article about this.) They also move money in and out of particular stocks. It's necessary to do so, of course, and a recent article by Russell Wermers at the University of Maryland presented data demonstrating that high-turnover funds from 1975 to 1994 outperformed the market on a net basis. We'll talk more about Wermers' findings in the future.

While they may have performed better as reported, high turnover has real costs to owners of funds subject to taxes. A KPMG study estimates that taxes erode 2.5 percentage points of annual return from the average equity fund. That's enough to kill off any outperformance, especially since it will be higher in high-turnover funds. Until now, however, mutual funds themselves did not suffer from the tax consequences of their moves. They had no incentive to restrain their turnover tendencies. As a result, average turnover has increased, ballooning from 33% in 1975 to 73% in 1994 to more than 100% today.

Important elements of the rule
No more. Starting Feb. 15, 2002, mutual funds' prospectuses will have to include annual results on an after-tax basis. The short-term gains tax rate will be the highest applicable level, currently 39.6%, to provide investors with a "worst-case" federal income tax scenario. Capital losses, however, will not be subject to annual caps, as they are in reality, but will apply in the year they are incurred. If you want to read more about it, the SEC has posted the full text of the rule on its website.

Note that funds will have to give this information in their prospectuses, but not in their sales and marketing material, unless they want to or claim to be managed in a tax-efficient manner. This is just one more thing that you can learn about a mutual fund by reading the prospectus rather than relying on misleading ads. We'll be holding a mutual fund seminar in May to teach you some of the other things to look for.

What does this mean for Rule Breaker?
I've written before about the treatment of taxes in this portfolio. The main point was that we were reporting results the way that mutual funds and the S&P 500 do, so that the comparison would be apples-to-apples. (Indices also give returns on a pre-tax basis. It is not yet decided whether it will be feasible to produce after-tax index returns.)

We, like mutual funds, have made our moves without consideration of tax consequences. We don't think that taxes should drive most investment decisions, but we certainly would have done some things differently had we suffered capital gain taxes. For example, our three sales of AOL Time Warner (NYSE: AOL) shares have cost us about $14,500 in taxes. We may have reconsidered, had we been faced with a bill.

But that's water under the bridge. From now on, we will take taxes into account, since our results are now being reported on an after-tax basis. To account for past taxes, we'll add cash to our portfolio on tax day for each of the previous years. We'll then buy and sell one share of a fictitious company, so that all the added cash is lost. That means that, in effect, we've added cash periodically. Therefore, we will soon begin reporting our internal rate of return.

I have posted a table that presents all our transactions and the tax consequences of each. For now, let's just say that our total tax hit will amount to about $31,700. The new annualized return is around 30.3%, compared to pre-tax returns of 13.7% for the S&P 500 and 13.1% for the Nasdaq. Those numbers will need updating in the daily numbers portion of our portfolio, which we will do in the near future.

For more help on investment taxes, there is the pleasantly affordable Motley Fool Investment Tax Guide 2001. Even if you don't need it for this year, there are plenty of helpful hints for good tax management of your portfolio.

Note: Because of problems with our data source, our numbers for the day, week, and month are currently incorrect. Rather than being down 6.3% today, our portfolio was up 1.8%. For the week, then, we are up about 4.4%, and for the month we are about even. Year-to-date we are down about 3.1%. Our returns since inception are accurate, now that taxes have been taken into account, but the annualized return needs to be changed to internal rate of return. That will occur on Monday, April 16.

Brian Lund actually enjoys doing his taxes. That's how big of a geek he is. The Motley Fool is investors writing for investors.