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-- Posted: May 1, 2000

Dorothy Rosen -- The Dollar Diva 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 taxed.

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.

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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

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, Schwab and T. 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 first.

-- Updated: Dec. 6, 2001

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