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) 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."
On the other hand, all the personal hand-holding associated with separately managed accounts can cost investors up to 2% of assets per year. That's almost double the expense ratio of the $5.9 billion Oakmark fund, which has a turnover ratio of only 16% and is managed by the well-regarded Bill Nygren. Richardson's fund carries a 97-basis-point expense ratio. "By buying funds that hold on to their gains rather than distributing them, you enjoy two big advantages," says Morningstar analyst Russel Kinnel. "First, you get to keep your money compounding in those mutual funds rather than pay it out in tax. Second, by deferring taxes into the future, you're making the most of the time value of money. ... If you put off a tax bill well into the future, you're effectively giving yourself a tax cut." You're also giving yourself a lot less to do come tax season.