1999 Lane Reports

The Mutual Fund Tax Muddle - Is It Worth All The Trouble?

Tuesday, June 1, 1999
by Marc J. Lane

The investing public has fallen deeply in love with mutual funds.

And who can blame small investors? Funds are popular because they offer a simple way to buy into a diversified, professionally managed portfolio. And, for years now, the wind has been at the managers' backs. Total investment returns have generally been outstanding and the public couldn't be happier.

The professionals at Marc J. Lane & Company, our investment affiliate, are less impressed. We acknowledge that mutual funds have an important role in investment planning. They are probably the best choice for very small investors who can't diversify their holdings in any other way. And specialty funds, such as foreign funds, make sense for investors who are trying to fill specific niches where "on-the-ground" intelligence is important. We also applaud the enormous growth of mutual funds-like 401(k) accounts, which "boomers" are counting on to achieve their retirement goals.

Where funds fall short is in strategic investment planning. Most investors are hard-pressed to mix and match fund managers' investment objectives and styles in a way that can reasonably result in a decent "asset allocation." Gaps and overlaps among asset classes are subtle, but can meaningfully increase portfolio risks. All in all, the investor with more than a few dollars to invest can probably see better performance at less cost by targeting individual stocks and bonds - and performance more reliably tied to her yield needs, risk tolerance and capital growth requirements.

To learn more about why we think mutual funds are overused - and how Marc J. Lane & Company helps people design and manage their own portfolios, visit our investments pages.

But, as much as anything, what makes us leery of mutual funds is the way in which fund investments are taxed.

The first problem is that funds pay out capital-gain distributions every year and fund investors are taxed on them. Fund managers often grab short-term opportunities; they dress up their performance by selling positions. In fact, many funds are active traders, and create huge, yet avoidable taxable gains for their shareholders. The funds' results don't reflect tax costs because it is their investors who pay the bill.

The disciplined investor might have preferred not to sell a stock at all, instead letting it continue to appreciate without any current tax burden. But that choice is only available to one who buys a stock directly, not through a fund.

Investors face another tax trap when they sell their fund shares. All kinds of complex rules are called into play when computing one's "basis" in his shares - that is, the cost, for tax purposes, against which gain or loss is measured. The rules get particularly tricky when dividends and capital gains are invested in additional fund shares.

When it comes time to sell fund shares, many investors don't realize they have a choice in how their basis is calculated.

  • The "first-in, first-out" ("FIFO") method assumes that shares are sold in the order they were bought. In rising markets, the cheapest shares - with the biggest taxable gains - are deemed sold first. The IRS loves this choice and, unless the investor opts otherwise, the IRS selects this choice for her.
  • The "average cost" method computes gains against the average price the investor paid for all his shares. This method is often a better choice than FIFO, but not without its drawbacks. For one thing, the investor must get IRS permission to use any other method later, when he sells more shares of the same fund. For another, "average cost" is a moving target; every time shares are sold it must be recomputed.
  • The "average cost, double category" method treats shares held one year or less and those held more than one year separately. Average cost is then calculated for each category. Long-term shares are deemed sold first and, if everything goes just right, taxed at a more favorable rate. A word of caution: to use either of the average methods, all shares must be held by a bank or other custodian or agent.
  • Finally, the "specific identification" method lets the investor choose exactly which shares are to be sold and, in that way, micromanage her tax planning. But, to qualify for specific identification, the investor is forced to maintain detailed accounting records and a "paper trail," evidencing her instructions to her broker and the fact that they were honored.

Ironically, the mutual fund investor who seeks simplicity and order buys complexity and, sometimes, chaos. Worse still, after-tax investment results may not measure up to those available through a more controlled, deliberate investment-selection process.

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The Lane Report is a publication of The Law Offices of Marc J. Lane, a Professional Corporation. We attempt to highlight and discuss areas of general interest that may result in planning opportunities. Nothing contained in The Lane Report should be construed as legal advice or a legal opinion. Consultation with a professional is recommended before implementing any of the ideas discussed herein. Copyright, 2003 by The Law Offices of Marc J. Lane, A Professional Corporation. Reproduction, in whole or in part, is forbidden without prior written permission.

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