Less-Taxing Investing

Mutual fund shareholders, get your No. 2 pencils and your green eyeshades ready. It's tax season once again and unless your fund manager acted as though every day was April 15 -- or, in this year's case, April 17 -- be prepared to account for a big year of capital gains.

Equity markets were up for a third straight year, and most mutual fund managers have long since exhausted their tax-loss carry forwards from the bear market. As a result, taxable capital-gains distributions doubled in 2005 from 2004.

Mutual funds are required by law to distribute at least 90% of their realized capital gains and dividend income to shareholders at the end of their fiscal year. That extra cash is taxable to you, whether you get a check in the mail or reinvest those distributions back into the fund.

According to Morningstar, the average diversified U.S. equity fund distributed 3.32% of its assets as capital gains last year, compared with 1.67% in 2004. The percentage of U.S. equity funds making capital-gains distributions rose to 74% from 64%.

One way to avoid getting socked with unpleasant capital gains each tax season is to invest in tax-friendly funds that manage money with an eye toward April. A few Morningstar recommendations include the Third Avenue Value fund (TAVFX), the Vanguard Tax-Managed Balanced fund (VTMFX) and the Oakmark fund (OAKMX).

Boston-based Eaton Vance (EV Quote) also specializes in the area, offering nine separate so-called "Tax-Managed Equity Funds," with strategies ranging from large-cap growth to small-cap value. The funds are designed to balance investment and tax considerations. Eaton Vance says the goal isn't to avoid taxes, but to maximize after-tax returns for the fund's taxpaying shareholders.

"Up to a quarter of an investor's return can be surrendered to Uncle Sam, and in a low-return environment like we experienced last year that can be meaningful," says Duncan Richardson, portfolio manager for the $19 billion Eaton Vance Tax-Managed Growth fund (EXTGX). "I'm patriotic, but you should not pay too much in taxes if you don't have to."