Too Much TaxBy: Phillip Roy Wasserman, Lakewood Ranch, FL.

Have you ever had the paranormal experience of holding a mutual fund that went down

in value, only to discover that you somehow wound up owing taxes on it? As strange as

it sounds, it could happen. How and why it happens is beyond the scope of this preview,

but the bottom line is sad but true — when investing in a managed mutual fund, you

have virtually no control of the taxes you pay while holding the fund.

If someone is interested in reducing tax, one of the first things they should ask

themselves is whether or not they are investing in managed mutual funds outside an

IRA. Investing in managed funds outside an IRA could result in taxable consequences

that are beyond your control. As a result, paying taxes each year on a fund only reduces

your return and that’s certainly not an efficient way to invest.

How much tax does your fund cause? Your tax return should give you a good idea as to

how much tax you’re paying on your funds. Another way of checking out the taxable

consequences of holding a fund(s) is to investigate something called “turnover” and

Morningstar.com is a good place to research this.

“Turnover” simply means “the amount of times a year the fund manager replaces the

portfolio with a different set of stocks.” If the fund manager changes the portfolio once a

year, that’s a 100% turnover. If the fund manager changes the portfolio two times a

year, that’s a 200% turnover, if the manager changes half the portfolio that’s a 50%

turnover, etc., etc.. Each time the fund manager “turns over” a portfolio, that usually

leads to one thing: paying tax, and in some cases, too much tax.

Certainly, there are some funds out there that are more tax efficient than others, but as

far as I’m concerned, the simplest way to reduce taxes on managed mutual funds is to

invest in the indexes instead. Remember: an index is a “passive” investment. There is

no one trading stocks within the index and given there are typically few trades (if any)

done within the index, there is often zero “turnover” that would cause taxable events

from taking place. Investing in the indexes often puts you in control of when you pay the

tax, not a fund manager out there making those decisions for you.