||Ask the Dollar Diva
Tax-friendly mutual funds
Dear Dollar Diva,
I took an unexpected tax hit because of $10,000 in unexpected capital
gains distributions from my mutual funds. Are there any funds that
provide good returns but do not distribute capital gains? I guess
what I'm really looking for are tax-friendly funds.
An unexpected tax hit because of mutual fund distributions
is a bummer. If your mutual fund is in a tax-deferred account, such
as an Individual Retirement Account or a 401(k) plan, tax efficiency
is not an issue. However, it's a big issue when your account is
A lot of folks are complaining about it, and the mutual
fund industry is paying attention by offering tax-friendly products.
They've also asked Congress to include the deferral of long-term
capital gain distributions in the economic stimulus package that's
in the works.
Stand up and be counted
Investors who own individual stocks, real estate,
precious metals or any other capital holdings do not get taxed on
their capital gains until they sell their investments; the same
should be true for mutual fund holders, many of whom are unsophisticated,
hard-working folks who are just trying to stay two steps ahead of
the game. Why should they be taxed on capital gains up front, just
because they don't have the financial savvy to pick individual investments
on their own?
The Diva urges all taxpayers who own mutual funds
outside their retirement plans to let their elected representatives
know that they are angry about this tax, and want to see the law
changed. Tell them that Congress most definitely should include
the deferral of long-term capital gain distributions in the economic
stimulus package under discussion. It will bring equitability to
the mutual fund investor and help the economy.
The Diva registered her complaint, loud and clear,
and wants you to do the same. Visit the Congress.com
Web site for links to the e-mail addresses of your federal, state
and local elected officials.
Capital gains tax
If you paid 20 percent on capital gains, your $10,000
distribution cost you an extra $2,000 in federal tax. That's $2,000
and a lot of compound growth and income gone forever. If you had
to sell a security and pay capital gains tax to come up with the
$2,000, it's even worse. Do this year after year and it can have
a serious impact on your investment results.
Index funds are mutual funds that track an index,
such as the S&P 500, and they are tax-efficient. Since companies
are rarely added or deleted to the S&P 500, funds that track
it rarely buy or sell, resulting in few transaction fees and capital
gains distributions. See "What
is an investment index?" for an explanation of the S&P 500
and other indexes.
Index funds have a lot going for them:
They're an easy way for both the novice and the
seasoned investor to participate in the market and achieve a
return almost as good as that of the index it tracks. There's
no stock picking involved; the fund selects the same stocks
as its index does.
They have low annual expense ratios, typically
under 0.5 percent for a fund tracking the S&P 500; you don't
have to pay a high-priced manager to make your stock picks.
It's easy to find index funds with no front loads:
Find them by surfing the Web's investment sites, such as Vanguard,
Rowe Price. The Diva reminds the investor of how
costly loads can be in "A
load is a heavy burden on your investment."
Index funds are buy-and-hold investments. To discourage
active traders from messing up the low-fee concept, index funds
sometimes charge a redemption fee. You can expect redemption fees
to range from 0.5 percent to 2 percent. If you're a serious buy-and-hold
investor, you'll cherish these redemption fees; they help your fund.
Tax-efficient actively managed funds
Tax-efficient funds can be index funds or actively
managed funds. As investors get more and more fed up with income
and capital gains distributions, more and more of these funds are
popping up. By surfing the Web you should be able to find some that
appeal to you.
When you find a couple of funds you like, start your
analysis by getting a free "Quicktake" report from Morningstar.
Of course no one should invest in anything without reading the prospectus
-- Updated: Dec. 6, 2001