Income Tax Reduction on Mutual Funds

New mutual administration may provide constructive adjustments-and also a bigger tax bill.

Mutual funds supervisors are staying on the job less and less these days, perhaps due to tighter industry competition: As of September 2006, the average mutual fund manager had been on the job for 4.44 yrs, down from 5.26 yrs in September 2004.1

For mutual fund investors, adjustments can possibly be good: New managers may bring new suggestions to the fund and possibly increase performance. But these new ideas are a double-edged sword: In the event the new supervisor sells undesirable holdings inherited from a predecessor, she or he could produce capital gains, which might be dispersed to the fund's shareholders and create for you just the opposite of income tax reduction.

As an example, think about the average yearly portfolio turnover for brand new managers. Portfolio turnover measures up the value of investments purchased and sold annually to the fund's total fund assets. For example, a portfolio turnover of 100% indicates the fund holds shares, on typical, for one year. A portfolio turnover of 200% means the fund holds shares for 6 months.

As outlined by Morningstar, the average yearly portfolio turn over for a manager who has been on the job two years or less is 98.65%, compared to 87.67% for a manager who has been on the job longer than two yrs. The reduced the turnover, the greater the possible income tax reduction from keeping this sort of a find.

Just how much can portfolio turnover affect you? As an example, in the spring of 2006, one Fidelity fund distributed $9.7 billion-nearly one-fifth of the fund's net asset value-in capital gains and dividends after new management reshuffled the huge fund's portfolio. Investors would have needed to look for tax offsets with other investment strategies in order to experience any income tax reduction that year.

Does that mean you should leave a fund which has a portfolio manager change? Not necessarily. Doing this might magnify your tax hit, because in addition to owing capital gains taxes on the fund's withdrawals, you will own capital gains taxes on your sale.

On the other hand, you might want to gain a sense of how much a new supervisor is changing the fund by taking a look at the fund's portfolio turnover. You might also wish to evaluate a tax hit in light of a fund's past performance. You can also look at the previous money that the new manager has directed. He may be an advocate of a low turn over strategy that delivers you income tax reduction. If your fund's had a great average annual return over the past five years, it might be simpler to tolerate the capital gains taxes. But when your fund performed poorly, capital gains taxes might be adding insult to injury.