Here's an iota of good news gleaned from last year's carnage in the financial markets--mutual fund investors experienced a smaller tax bite than in 2007. Cold comfort, for sure, but every little bit helps considering mutual fund investors experienced the worst one-year return in decades.
According to Lipper, the mutual fund research company, equity funds on average sank 39.54% last year, the lowest level since Lipper began tracking funds in 1959, and significantly worse than the previous lowlight year of 1974, when equity funds dropped 24.35%. And even if taxable and tax-exempt funds did "better," they still lost an average of 7.62% and 7.46%, respectively.
But these large shortfalls helped reduce the tax drag on mutual funds. Estimated taxes paid by mutual funds in 2008 fell 53% from the record amount in 2007. Lipper calculates that buy-and-hold taxable mutual fund investors last year forked over $15.8 billion in taxes to Uncle Sam, which roughly tracks the 10-year average. But given how badly funds performed, that's still a hefty tax bill. "Personally, I think $15.8 billion is an atrocity," says Lipper senior research analyst Tom Roseen.
And depending on the asset class, some investors fared better than others. Equity funds, for example, saw hefty declines in both short-term and long-term capital gains last year--84% and 79%, respectively--from the prior year.
On the flip side, taxable fixed-income fund investors took it on the chin by accounting for 40% of the overall tax bill footed by mutual fund investors even though taxable fixed-income funds comprised just 11% of assets under management in the open-end funds universe.
Roseen cites two reasons for that. One, income distributions from fixed income are taxed at the highest marginal tax rate, which this year is 35%. (Roseen used a more conservative 28% rate when estimating taxes on taxable fixed-income funds.) Second, taxable fixed-income funds saw short-term and long-term capital gains distributions balloon by 182% and 296%, respectively.
Municipal funds fared much better on the tax front, and not just because they're inherently tax-free investment vehicles at the federal and state levels (assuming you buy a state-issued fund and are an in-state resident). Munis still have taxable events that entail paying short-term and long-term capital gains. Lipper estimates that the tax hit on muni funds dropped 25% last year from 2007--thanks to declines in short- and long-term capital gains distributions.
For investors, last year's abysmal funds performance should help replenish the tax-loss carryforwards that had basically run dry during the bull market years following the tech wreck. Roseen partially attributed the record mutual fund-related taxes in 2007 to the fact that most of the carryforwards from the 2000-2002 period had worked their way through the system and were no longer available to offset taxable gains. That probably won't be a problem in the near term. "The big downturn will be beneficial for the next several years," he says.
Roseen says fund investors typically underestimate the impact taxes have on their investments. He suggests that fund investors employ some measure of tax efficiency as a secondary screening criterion to avoid needlessly handing over money to the tax man. He adds that advisors can help mitigate the tax bite by putting high-income-paying funds into tax-exempt accounts and tax-efficient funds into the taxable portion of a portfolio.