Mutual Funds: Tax Toll of Picking Funds

Oct. 23 -- With stocks making a comeback, many mutual fund investors have been looking to jump back into the market. But they would be ill-advised to adjust their holdings without considering the tax consequences.

Federal taxes on average eat up about 2.5 percentage points, or up to 25 percent, of a taxable stock fund's returns for investors in the highest tax bracket, according to Lipper Inc. That's even higher than the average 1.2 percentage point hit for expenses.

"Investors should make sure what best fits a portfolio and the tax ramifications as well, rather than buying or dumping at will," said Tom Roseen, research analyst at Lipper.

In particular, investors right now should avoid buying into a fund before the company makes its capital gains distribution to ensure they aren't unduly taxed on gains from earlier in the year. Other options include tax-managed funds that seek to lower taxable distribution and index funds with typically low turnover.

Investors don't need to worry about tax-deferred accounts such as 401(k) retirement plans or individual retirement accounts, which aren't taxed until investors withdraw the money.

But for other accounts, investors not only are taxed on their capital gain after selling shares, they also can be taxed for simply holding on to their shares. That's because investors are taxed for dividends and interest even if they reinvest them; they also must pay capital gains realized after a fund moves in and out of stocks and bonds.

In addition, fund companies distribute their accumulated capital gains between October and December each year. So investors shouldn't buy right before the distribution — they could be taxed on gains they didn't benefit from earlier in the year and then end up with a fund that's worth less after the distribution payout.