How the Pros Steer Clear of the Tax Bite

Even investors who understand the overall benefits of tax-efficient mutual funds -- and those of you who don't should read "You Can Spare Returns the Tax Ax" -- view tax management as little more than the matching of capital gains with losses.

As with everything that involves taxes, there's a lot more to the story.

Tax-efficient funds (whether they bill themselves as such or not -- see "Funds That Can Keep Taxes Low Can Save Your Portfolio") employ several basic strategies. And while many of these strategies are implemented more efficiently on the grand scale of fund management, most of them provide a relevant (and eminently workable) structure that individuals can implement in their own portfolios. Whether investing through a mutual fund or via your own through individual issues, tax management is vital to keeping your gains -- particularly when those gains are far more anemic than what many investors have become accustomed to.

Clearly, one of the most basic strategies involves taking a loss each time a manager is forced to take a gain. Now, many investors would like to think that their actively managed fund simply doesn't hold any losses -- after all, if it did, how would they ever make any money? Well, here's a news flash: All funds have losses somewhere in their portfolio. Even concentrated funds that own just a few stocks, or funds that keep turnover to a minimum -- all hold shares of varying cost bases, and depending on when they were acquired and where the market is now, a fund could easily hold a multitude of shares in a single company, some of which have unrealized gains, some of which have unrealized losses. It's just the nature of mutual funds and the market.

None of that necessarily has any bearing on your own overall gain or loss. Clearly, even funds that doubled your money during the bubble held losses somewhere in their portfolio.

"A lot of funds have huge unrealized losses," says Morningstar senior analyst William Harding. "But tax-managed funds realize those losses and use them to their benefit."

Exactly how they do that, though, takes the simplistic strategy of matching losses with gains to a more sophisticated level.

But Wait -- There's More

Vanguard's plethora of tax-managed funds, for instance, employ a variety of strategies that go way beyond selling shares at a loss to offset any gains. Indeed, many aspects of tax management aren't even engaged at the manager's decision-making abilities.

For instance, the funds all start off as index funds, "so they immediately benefit from the low turnover and slow realization of capital gains," says Brian Mattes, a spokesperson for the Vanguard Group.

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But "tax efficient" doesn't necessarily equate with "low turnover." Indeed, there are several techniques that fund managers, traders and their accountants can use to minimize taxes that don't rely on keeping turnover to a minimum.

All of Vanguard's tax-managed funds, and many other tax efficient funds from other families, employ HIFO accounting -- that's "highest in, first out." This method of choosing which specific shares get sold is handled by the portfolio's accountants, rather than the manager. "We sell the shares with the highest cost basis first," Mattes says. "We can almost always harvest a loss that way." That's not to say that the individual fund investor is losing, though. Remember, these funds buy and sell a multitude of shares of the same company over a number of years. Consequently, the shares they'll hold of a single company were all bought at different prices.

Due to the cyclical nature of the markets that we've all become all too familiar with, funds almost always hold shares that were bought at one time at a higher price than they currently trade for in today's market. The HIFO method of accounting enables the fund to cherry-pick losses, rather than incurring gains.

Those losses can be used to offset gains that can't be avoided, or they can go toward building up the fund's tax-loss carryover. Just as individuals can carry forward any losses that exceed their gains (and $3,000 of ordinary income), mutual funds can carry losses forward as well, using them to offset future gains. Vanguard's tax-managed funds started building up tax losses they could keep on their books from their inception in the early to mid-1990s.

Losses are also harvested to meet shareholder redemptions. Vanguard tries to keep redemptions to a minimum by imposing a charge for any redemptions made within five years. Redemptions made within one year incur a 2% fee, a 1% fee is imposed for the next four years.

"Up to 50% of the capital gains realized by mutual funds are due to shareholder redemptions," Mattes says, citing a study conducted by Vanguard's Joel Dixon during his time at Stanford University. "The benefits of tax management accrue over time, and we want investors that will stick with it over time."