One for your money: a year-end run for mutual funds

Black Enterprise, Nov, 1998 by James A. Anderson

Conventional wisdom says that investing money in a stock mutual fund late in the year is about as appropriate as prancing about in shorts and sandals around November 30. And for good reason: late in the year mutual funds pass on their tax burdens to unsuspecting investors like you and me, whether you got into the market January 1 or just after Thanksgiving. The result may be that during the past few years you've paid for a mutual fund's grand gains even if you didn't get the full benefit.

That's not always the case, however. There are a few stock funds that investors can put money into without worrying about whether or not they're paying taxes and getting the most for their savings.

First, it's a good idea to look at how mutual funds tally taxes and pass on much of that burden to you, the fund holder. Over the course of a typical year, a stock fund buys and sells stocks, shuffling its portfolio at a rapid rate -- a phenomenon labeled "turnover" in investing circles. Scott Cooley, a mutual fund analyst for Morningstar, the Chicago firm that keeps an eye on the industry, says the average stock fund has a turnover rate (the percentage of its portfolio sold and replaced in any given year) of 90%, as funds replace their holdings with new ones. For you, that isn't a problem until December, when those stock sales generate gains that are taxed by the Internal Revenue Service.

The funds themselves, however, don't foot the bill. The gains amassed over the year are passed on to investors in the form of a distribution. In turn, you, the fund holder, pay whatever taxes are due on that distribution. If you've been in the fund since early in the year, you've at least seen your fund's asset value appreciate as those trades have occurred. Jump in toward year's end, and you don't get that additional appreciation. What's more, those distributions don't get to grow over time like the rest of your investment.

There are ways to still invest in mutual funds toward the end of the year and duck the capital gains distributions. One obvious way is by making contributions to any mutual funds you hold in tax-deferred accounts like IRAs or employer-run 401 (k) matching plans. By law, you're not taxed for any distributions; you're only taxed upon withdrawal.

Outside of those programs, though, there are a couple of other ways to avoid or minimize a sizable bill from Uncle Sam -- if you invest in the right kinds of funds.

Choose funds that keep their turnover to a minimum, and therefore have little in the way of capital gains taxes to pass on to you. These index funds fill that bill.

The Vanguard Index 500 Fund (ticker: VFINX; 800-662-7447), commonly rated the Cadillac of the group in efficiency, has an annual turnover rate of a mere 5%. At the end of 1997, the Vanguard fund distributed 59 cents for each of its shares, and carried a $90 net asset value. Compare that to Fidelity Magellan (ticker: GMAGX; 800-544-8888), one of the most popular funds around, which doled out $5.21 for a $95 share in 1997 (own from $12.85 in 1996, when shares were valued at $80 each). Remember, too, that a number of financial companies run index funds besides Vanguard.

In addition, a number of mutual fund companies offer tax-managed funds. Tax-managed funds strive to keep turnover to a minimum and therefore keep a lid on capital gains distributions. In other words, they mimic a lot of the strategies index funds have made successful. Morningstar's Cooley says one of the best tax-managed funds that carries no sales load is Vanguard's Tax Managed Growth and Income Fund (ticker: VTGIX), which has averaged an annual total return of 28.39% over the last three years. Last year, it held turnover to a scant 2%, and had no capital gains distribution.