Mutual Fund Managers Avoid the Tax Man

NEW YORK (TheStreet) -- Taxes can infuriate mutual fund investors. Some investors get socked with tax bills nearly every year, including times when funds suffer losses.

But now because of peculiar conditions, some top-performing mutual funds offer important tax shelters. Even if the stock market climbs for the next several years, shareholders could be protected from taxes. The tax advantages are so compelling that investors who normally buy individual stocks may prefer conventional mutual funds.

To appreciate how the tax holiday has occurred, consider that shareholders can owe capital gains taxes any time a manager sells appreciated stock. But gains can be offset by trading losses. When losses equal gains, the shareholder owes no tax.

If a mutual fund has more than enough losses to offset gains during a year, the manager can store the losses, carrying them forward to use in the future. At the moment, many mutual funds have sizable stockpiles of losses left over from the downturn of 2008. The losses are so great that many shareholders aren't likely to face capital-gains tax bills for years.

To determine the tax status of mutual funds, Morningstar recently studied what it calls potential capital-gains exposure. Say a fund has stockpiled losses equal to 10% of its assets. Morningstar says that the fund has potential capital gains exposure of minus 10%. The average large-growth fund has potential gains exposure of minus 37%. In other words, the funds would have to book gains of 37% before the losses would be exhausted and shareholders would face tax bills.

The stockpiled losses are particularly intriguing now because tax rates are likely to rise next year. That will make shelters more valuable.

Should you buy a fund just because it has stockpiled losses? Hardly. Some poor-performing funds have generated losses for years. Instead, you should consider funds with strong records. If two funds have equal records, pick the one with the more promising tax outlook. Keep in mind that a good fund may have what's called a tax-loss carryforward because of a single difficult year or unusual circumstances.