3 Funds for After-Tax Profits

NEW YORK (TheStreet) -- Fund investors have enjoyed a tax holiday. Although stocks recorded big returns in 2009 and 2010, fund shareholders were largely shielded from paying capital gains taxes. The respite occurred because nearly all funds suffered big losses during the financial crisis. Under IRS rules, losses can be stockpiled and used to offset future gains. Say a fund suffered a 40% loss in 2008 and gained the same amount the next year. The loss could offset the gain, and the shareholder would owe no tax.

But lately some funds have been recording healthy gains and exhausting their supplies of losses. As a result, shareholders will face bills this year. Funds that have warned shareholders to expect taxable capital gains include Fidelity Blue Chip Growth (FBGRX), T. Rowe Price Mid-Cap Growth (RPMGX) and Vanguard Capital Opportunity (VHCAX). If markets continue climbing next year, more funds will begin generating tax bills.

To avoid facing bad news on April 15, investors can turn to tax-managed funds. Some of those have long histories of avoiding taxable gains. But investors should shop carefully. Of the dozens of funds that claim to be tax-efficient, only a few have delivered strong returns while limiting payments to Washington. Among the winners are BBH Core Select (BBTEX), Russell Tax-Managed U.S. Mid & Small Cap (RTSAX), and Vanguard Tax-Managed Capital Appreciation (VTCLX).

Vanguard Tax-Managed has been an especially compelling choice. During the past five years, the fund has returned 0.7% annually, compared to a return of 0.1% for its benchmark, the Russell 1000 Index, according to Morningstar. Since the fund started 17 years ago, it has never reported a taxable capital gain. Vanguard Tax-Managed follows a strategy that is basically passive, though the managers tweak the holdings to avoid taxable capital gains.

The fund starts with a portfolio that roughly resembles the Russell 1000. To limit capital gains, Vanguard uses a technique known as tax-loss harvesting. In the approach, the managers sell some shares that have declined. That way the fund can book the loss and use it to offset gains. After selling the shares, the fund must stay away from the stock for 30 days to avoid running afoul of IRS wash-sale rules.

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