Congress Quiet On Capital Gains Tax

In 2001, "the mutual funds didnt have these gains because theyve distributed most of them out," says Norman Tamkin, a tax partner in the accounting firm of Holthouse Carlin & Van Trigt L.L.P., Los Angeles.

Capital gains distributions for 2001 fell to $72 billion, the lowest level since 1995, according to ICI.

The capital gains problem could return later this year if the stock market continues to rally, but fund managers might buy some time by using embedded losses on poorly performing stocks to offset gains on more successful stocks, Tamkin says.

A wave of articles that appeared in early 2001 described employees who exercised stock options from their employers shortly before share prices collapsed. Because of a provision called the alternative minimum tax, some of those employees ended up with a few thousand dollars in their investment accounts and obligations to pay hundreds of thousands of dollars in AMT taxes.

Taxes on fund distributions are usually not that devastating, but they can cause serious financial headaches, Tamkin says.

Although officials at the Internal Revenue Service will arrange installment payment plans, Tamkin had a hard time thinking of an example of the IRS voluntarily forgiving income taxes on mutual fund capital gains distributions simply because a taxpayer was unaware of the relevant tax laws. "The IRS wants to get paid," Tamkin says.

The idea of taxing small, "buy and hold" investors who have lost fund asset value but are still plowing distributions back into a fund seems especially unfair, Tamkin says.

Because the buy-and-hold investors never see any cash, "its kind of phantom income," Tamkin says.

How To Help

Advisors can help some fund investors minimize capital gains taxes by attending to basic financial planning concerns, such as persuading investors to buy variable life insurance and contribute to tax-exempt retirement accounts, such as Roth Individual Retirement Accounts, Donoghue says.

But "a lot of people cant put enough money in their retirement plan," Donoghue says.

This year, in spite of the many changes in the Economic Growth and Tax Relief Reconciliation Act of 2001, the limit on IRA contributions is still only $3,000 for individual taxpayers.

EGTRRA increased the maximum 401(k) plan contribution to $11,000, and $12,000 for workers over age 50. But many employers impose lower limits, and socking large sums of cash away in a badly designed 401(k) plan is probably a bad idea, Donoghue argues.

Many consumers will want to consider taxable mutual funds or comparable vehicles once they have about $5,000 in investable, taxable cash, Donoghue says.

Investors who prefer ordinary, open-ended mutual funds can look for "tax efficient" funds.

The new SEC disclosure rule should help investors shop for funds with strong after-tax returns.

Morningstar Inc., Chicago, also suggests using a funds "portfolio turnover rate," or the percentage of holdings sold each year, as a rough indicator of its tax efficiency relative to other funds in its class. All other factors being equal, a lower rate is better than a higher rate, Morningstar says.

A Morningstar fund screener shows, for example, that 83 of 426 U.S. stock mutual funds with more than $1 billion assets are reporting annual turnover rates of less than 20%. Two of those funds have one-year returns greater than 10%.

Investors who worry about sudden increases in turnover rates and investors who want to trade and short mutual funds as if they were stocks can invest in exchange-traded funds.

An investment company creates an ETF by depositing a block of securities, such as stocks picked to mimic the S&P 500 stock index, with the fund. The investment company then sells stock backed by the fund securities to the public and lists the fund stock on an exchange, ICI says.

The investment company can trade its own ETF shares for the underlying securities, but retail investors can only buy and sell shares on the exchange, ICI says.

ETFs do pass on ordinary stock dividends, and an ETF will realize some capital gains. An S&P 500 index ETF, for example, might sell stock when a company leaves the S&P 500, according to the Nasdaq Stock Market Inc., New York.

But ETF rules limit the ability of panicked retail investors to increase turnover rates by asking for their money back, and the capital gains distributions and dividend payouts tend to be relatively small, experts say.

Sophisticated investors with steady nerves and a large amount of taxable assets could consider "separately managed accounts," or "separate accounts."

A "separate account" is what used to be known as a "large, diversified securities portfolio."

The investor buys a bundle of stocks designed to mimic the behavior of a stock index, or a mutual fund. The investor can limit capital gains distributions by deciding when to buy or sell the individual stocks.

Traditionally, investors have needed at least $100,000 to set up the equivalent of a miniature, personalized mutual fund. Today, advisors at companies such as BridgePortfolio.com Inc., Chicago, say they can use technology and packaged investment strategies to lower the minimum to as little as $10,000.

Guardian Life Insurance Company, New York, and John Hancock Financial Services Inc., Boston, are two examples of large, well-known financial services companies that market separate accounts to affluent customers.

Reproduced from National Underwriter Life & Health/Financial Services Edition, March 18, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.

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