|
|
|
|
The Double Whammy: Record Tax Distributions in 2000
From FundScoop Studies and Research Articles
hen fund investors got their year-end fund statements in the mail, no eyebrows were raised. The market downturn, which began in the spring, was no secret to investors. Most of them knew what to expect, even though they didn’t like it. But what they did not foresee was the unusually-cluttered 1099 tax form, informing them of their tax-liability on their fund investments in a year dominated by nothing but meager returns. The issue of excessive fund taxation is not new to the market. Industry participants have long argued that taxes, coupled with expenses, will all but ensure that most mutual funds will lag behind the overall market. Their argument has proven valid in some cases and during certain time periods. But the advent of 401(K) plans, and the introduction of similar tax-deferred and tax-sheltered investment vehicles, have significantly eased the pressure on the industry. At present, over half of the industry’s seven trillion dollars are in such qualified plans, thus effectively keeping it out of the reach of Uncle Sam, at least for the time being. But the other half, well over $3 trillion in assets sitting in venerable taxable accounts, remains to be under a lot of heat from concerned investors and active shareholder’s advocacy groups. Not that any one expects to avoid taxes all together on investments, especially professionally managed investments. But the real burden is when these tax distributions come in at very high levels, and worse yet, when they come in after a loss. This is what the industry calls the “double whammy,” and last year, was the first time in a long while that the industry has experienced this dreaded occurrence.
When It All Began
If the year 2000 had such poor returns all across the board, then where are the capital gains coming from? Remember 1999, when the markets jumped by leaps and bounds and hundreds of mutual funds posted all-time high yearly returns. Remember when the NASDAQ soared over 85% that year and then went into the new year to break the 5,000 mark for the first time ever. Well, that’s when it all began. These unprecedented gains in the form of price-inflated tech stocks, and other sectors’ stocks, were worse than a time bomb. When the markets started falling in mid March and investors took notice, redemption requests poured in droves, as investors suddenly worried that this could be the beginning of the end. Of course, fund companies are required by law to hand investors back their money on demand. However, the law does not requite fund managers to maintain a certain level of cash reserves for that purpose. And with 1999 and the early part of 2000 being as generous as it was to the markets, very few fund managers felt it was necessary to set aside high levels of cash. Instead, many opted to be fully invested and rationalized that it would be a waste to leave any portion of the portfolio’s assets sitting idle during one of the market’s best winning streaks ever. By the end of the first quarter in 2000, the average equity fund, sector and diversified, was 98.99% invested in stocks. As a result, when the large slew of redemptions suddenly appeared, fund managers from various investment categories found themselves faced with no other solution but to sell some of their holdings to raise cash. Under normal circumstances, this would not have been such an extreme measure. But at the price levels at which some of these stocks were trading, and despite the pull back they had at the time, selling at this point all but meant a huge capital gains hit. The unrealized gains achieved over years and years of spurt growth were now suddenly scheduled to be passed on to investors unexpectedly, and to that end, unintentionally. But the investor’s wallet gets hit regardless of the fund companies harmless intentions. By year end, when the majority of the distributions were made, most equity mutual funds were deep in the red, which quite simply, added insult to injury.
Double Trouble
Of the 6,000 plus equity funds available at the end of the year, a total of 2,841 funds had negative returns for 2000. Of this total, some 2,311 funds made capital gains distributions during the year. The highest of which made an unheard-of 65.38% disbursements of capital gains on a portfolio that fell nearly 20% for the year. The Standish Small Cap Equity Fund ranked first in this year’s “cap gains” contest, closely followed by Delaware Pooled Mid-Cap Growth Equity, which made a similarly heartbreaking 62.00% distribution on a loss of 9.71%. Of note, the funds were up 79.10% and 66.98% in 1999, respectively, which explains the magnitude of these taxable distributions. But without a doubt, the “double whammy” trophy goes to Apex Mid Cap Growth fund, which after plummeting 75.69% for the year, passed on a total of 21.79% in capital gains distributions to its very unfortunate shareholders. All told, the average domestic equity fund made a distribution of 9.19% with a yearly return of 0.89%, topping the record set in 1981 of 8.18%. And on the international end, the picture was even bleaker, as the average non-US equity fund disseminated 9.29% of taxable gains, barely tailing the record set in 1987, when a record 12.40% in taxable distribution was made. Not a big surprise, given that many foreign stock markets, including Japan and Europe, experienced the same unjustified growth in the years prior to 2000.
The Tax Law
Not to loose track of what’s in issue here, but these horrifying figures warrant a quick review of the laws and regulations surrounding mutual fund taxation. The SEC states that in mutual funds, taxes are triggered in one of two ways. If one of the stocks in the fund’s portfolio makes a dividend payment, the fund passes on the dividend payment to the fund’s shareholders. The investors then, in turn, have to report the distribution on their tax forms at year end. The dividend distributions are treated as ordinary income. So the tax rate on dividends can range anywhere from 15% to 39.6%. Similar to dividends are interest payments made by debt securities held in the portfolio. The securities, which could be anything from a muni bond to a Treasury Bill, are either tax-exempt or taxable. If taxable, the investors have to report the interest received as income and, like dividends, the investor’s personal income tax rate will be used. The other way taxes are triggered in a mutual fund, and the one in question here, is when the fund manager sells one or some of the portfolio’s holdings at a profit. The gains distributed to shareholders are in effect capital gains distributions, and they too have to be reported on the investor’s Federal income tax return. The capital gains distributions can either be long-term or short-term, and each type carries a different tax treatment. Long-term capital gains, which result from selling securities held for more than 18 months, are taxed at the lower of 20% or the investor’s tax bracket. Since most investors are likely to fall in the 28% tax bracket or higher, the rate used is usually 20%. Short-term capital gains, resulting from selling securities held for less than a year- and-a-half, are to be treated by investors as income. So the tax rate used will be the same one the investors use for their personal income. Needless to say, short-term capital gains are more dreaded than long-term ones since the tax rate will usually be higher than the 20% typically used for long-term capital gains. The law, however, permits individuals to deduct up to $2,000 of capital gains distributions from their taxable income ($4,000 for couples), given that the distributions were invested back in the fund. But predictably enough, the law does not prevent losing funds from making taxable distributions during the year in which the loss was incurred. Nor does it mandate the fund to give an early warning of a potential distribution. Due to the increase and the magnitude of the problem, however, the SEC is now revamping its regulatory procedures to allow investors to gain a better insight into how their funds really fare after adjusting for taxes. According to the government agency, the average fund loses more than 2.5 percentage points of its annual returns to taxes!
Time For Clarity
In the first of its long list of tax-easing efforts, the Securities and Exchange Commission has adopted a rule calling for mutual funds to disclose after-tax returns based on standardized formulas. In its new rule, the SEC requires a fund to disclose its standardized after-tax returns for one, five-and 10-year periods, along with pre-tax returns, in the risk/return summary of its prospectus and in any fund profile. The tax rates to be used in calculating the standardized returns are the maximum rates for short- and long-term capital gains in the years covered. And in another closely-watched political move, Jim Saxton, vice chairman of the Joint Economic Committee reintroduced a bill to lift the allowable taxable distribution deduction from its current levels to $3,000 per individual and $6,000 for married couples. A provision was even included to apply these rates retroactively to the year 2000, the main culprit here. While no laws have been endorsed as of yet, the industry is watching anxiously.
Can We Avoid The Tax Man?
But until some of these laws come into effect, there are other ways you can avoid a large tax bill. For one, always try to own mutual funds through a tax-deferred or tax-sheltered account. If not, then consider tax-efficient funds, not just the ones that claim they are, but the ones that actually have high tax-efficiency records. Keep track of the fund’s turnover ratio and trading activities. While not necessarily a decisive factor, funds that are too active typically trigger severe tax consequences. Keep an eye for manager changes, new management usually overhauls the fund’s portfolio, thus inducing a tax bill. Most importantly, do not chase last year’s winners simply because they posted a stellar calendar year return. Stick to the funds with solid long term track records. In the end, while we can not control the fund’s tax activities, we most certainly can control which fund we decide to invest in.
|
Sponsored by James J. Eccleston. This Web site contains material of general interest. It is neither intended to, nor constitutes, either legal advice or investment advice.
Always consult an attorney and/or investment adviser when building and protecting your wealth.
All content Copyright © 2010 Advocate Compliance Partners, Inc. except where noted. All rights reserved.
One North Franklin Street, Suite 2620, Chicago, IL 60606
Telephone 312-332-0000 | Fax 312-332-0003
|
|
|
|
|
