2014 Tom Madell, Ph.D.

Mar. 2014

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Mutual Fund/ETF Research Newsletter

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Selling a Fund? Don't Overpay on Your Taxes

by Tom Madell

It's tax time once again. While discussing taxes may make for dreary reading, it's a subject that all investors should likely take note of if they want to best retain what their investments produce. The alternative is to risk sending off too much in tax payments that might otherwise be avoided.

So in this month's Newsletter, I will present information I have uncovered on two aspects of fund investing that very few investors will be aware of, especially in the article below.

I'll start with an highly misunderstood revelation that apparently even tax professionals aren't getting right, and therefore, can sometimes lead you to report and pay significantly more in taxes than necessary, which came about starting in 2012.

The best way to show how problematic this first issue is through an example.

Suppose after making several purchases of a fund in your taxable account after the market bottomed out in early 2009, you decided to sell some of your position at the end of 2013 having achieved very significant gains.

Obviously, you recognize that you will have to pay capital gain taxes but the question is how much. In past years, you may have relied on either information provided by your fund company, your tax preparer (or tax preparation software such as TurboTax), or your own calculations based on your record of purchases.

But what would you do if it turned out you were paying far more in taxes than you needed to pay, even potentially hundreds or thousands more? This

Selling a Fund? Don't Overpay on Your Taxes, continued on page 6

How Much of Your Investment Return Are You Losing to Taxes?

As in the companion article to your left, doing well in your investing entails not only achieving a good return, but in retaining as much as possible of that return after Federal (and possibly state taxes) are paid.

In this article, I will compare a variety of funds and ETFs to see the degree to which you may have to pay taxes each year on your distributions. It should be apparent that the more you have to pay in taxes arising from your investments, the less your portfolio will grow over the long term. And higher taxes due each year will reduce your pre-tax performance to a lower level on an after-tax basis.

In most past articles in this Newsletter, I have focused on helping readers to obtain the best absolute returns. But absolute returns, like many other increases in potential wealth, do not present a complete picture. Each year, you likely have to turn over some of your earnings to the government in the form of taxes on your investments held in taxable accounts, just as you do with salary earned. (Of course, for investments held in tax-deferred accounts such as IRAs and 401(k)s, taxes are only due when you start receiving distributions, usually in retirement.)

If you own individual stocks as opposed to mutual funds, your tax bite may be more under your own control. While you may similarly receive dividends from stocks, you will not owe anything else unless you sell that stock during the year. In that case, you may have either a capital gain or loss, depending on how well the stock did since the time of purchase. But, as you likely know, with funds, including ETFs, you may receive dividends AND capital gains distributions even if you sold nothing and even if the stock market has a down year. (Additionally, if you sell or exchange out of a fund, you may generate an additional capital gain depending upon your profit or loss.)

Thus, while individual stocks allow you to postpone taxable capital gains and therefore build up wealth by continually deferring taxes, with funds, you may not as easily come by this benefit. However, with a little additional work on your part, you can try to choose your fund investments so that they come considerably closer to the individual stock tax deferral advantage without exposing yourself to the

continued below

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Mar 2014


(How Much of Your Investment Return Are You Losing to Taxes?, continued from page 1)

additional burden of analysis and the higher degree of risk that comes with owning individual stocks.

Model Stock Portfolio Tax Analysis

In order to get a better idea of the role of taxes in reducing your "take home pay" so to speak, let's look at the funds/ETFs within my Model Portfolios, giving you an approximate estimate of how much a typical investor loses each year due to taxes on distributions, and then showing what prior 10 year performance would have been once those costs were factored in. (Note: The tables below only reflect Federal, not state taxes. If any, such state taxes will need to be considered to arrive at an more reduced after-tax return.)

The benchmark against which most stock funds can be compared is to a low cost S&P 500 index fund, such as Vanguard 500 Index (VFINX), a fund which is included in our Portfolio.

Jan. '14 Model Stock Fund Portfolio

Our Specific Fund Recommendations

Annual
Tax Cost

10 Year Annualized
Return (Approx.) After Taxes
(Thru Feb 25, 2014)

Fidelity Low Priced Stock (FLPSX)

1.00%

9.15%

Tweedy Brown Global Value (TBGVX)
Vanguard Internat. Growth (VWIGX)
Vanguard Pacific Stock Idx (VPACX)
Dodge & Cox International Stock (DODFX)

1.00
0.70
0.35
0.65

7.25
7.30
5.55
8.60

Vanguard 500 Index (VFINX)
Yacktman Fund (YACKX)

0.30
0.90

6.70
8.90

Vanguard Growth Index (VIGRX)
Fidelity Contra (FCNTX)

0.15
0.50

7.60
9.80

Vanguard US Value (VUVLX)

0.60

5.90

Vanguard Financials ETF (VFH)

0.50

0.25

Vanguard Energy ETF (VDE)

0.40

11.0

Vanguard Consumer Staples ETF (VDC)

0.40

9.20

Note: Vanguard Energy ETF has not been in existence for the 10 full years; results shown are estimates based on available information for life of the fund.

For further reference, you may be interested in the data for Vanguard 500 Index Admiral (VFIAX) (10K minimum), or a closely identical ETF version, such as iShares Core 500 ETF (IVV). And, since many investors invest internationally as well, we should consider taxes paid when investing in such an international index fund as well.

As you can see below, using a slightly lower expense ratio S&P 500 index fund (VFIAX) available with a higher balance only adds a 1/10 of a percent better after-tax return than VFINX; an alternate ETF produces the exact same after-tax return.

Alternative Benchmark Funds

Annual
Tax Cost

10 Year Annualized
Return (Approx.) After Taxes
(Thru Feb 25, 2014)

Vanguard 500 Index Admiral (VFIAX)

0.30%

6.80%

iShares Core 500 ETF (IVV)

0.35

6.70

Total Intl Stock Index Inv (VGTSX)

0.45

6.35







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Mar 2014

How to Make Use of This Data

Over the last 10 years, each of the three S&P 500 funds have returned about 7.0% annualized on a pre-tax basis. After distributions, and assuming the investor is in the 28% Federal tax bracket, the return is reduced by approximately 0.30 to .35% annually. This is derived from the estimation that such funds paid about 2% per year in dividends and likely no capital gains. Since such dividends are taxed generally at a 15% rate, the 2% dividend subjects one to a tax due of approximately 0.30% of the entire investment (total investment x 2% x 15%).

In other words, in the best of all worlds, one might estimate this to be about the minimum one can expect to lose to taxes when investing in a highly tax efficient fund such as a low turnover index fund or ETF.

Many investors do not take account the high tax costs of their funds when considering which stock funds to include in their taxable accounts. In some cases, while it may appear that their funds are doing well, when taxes are taken into account, their funds' after-tax return may be sub-par.

As you can see, the two funds in our Model Portfolio with the highest annual tax burdens (FLPSX and TBGVX) still came out ahead of the low tax cost S&P 500 index funds on an after-tax basis (And, additionally, these two funds had higher expense ratios as well.) Therefore, the argument that investors should only choose the lowest cost funds fails to take account of the fact that some funds on occasion are worth the higher cost. But as a general rule, it tends to be true that investors should pick tax efficient (and low expense ratio funds), especially for their taxable accounts.

Only a few of our Model Stock Portfolio funds failed to surpass the after-tax return of the S&P 500 benchmark funds. It should be noted though that we did not recommend most of these funds over the entire 10 year period.

Let's look at the comparable data from a few tax-inefficient funds as also judged over the last 10 years. There was no particular reason for picking these particular funds, other than the fact they showed relatively high annual tax costs.

Stock Funds that Lag on an After-Tax Basis

Annual
Tax Cost

10 Year Annualized
Return (Approx.) After Taxes
(Thru Feb 25, 2014)

Alger Mid Cap Growth I-2 (AMGOX)

1.55%

5.65%

BMO Mid-Cap Value Y (MRVEX)

1.05

7.35

Wasatch Ultra Growth (WAMCX)

0.90

4.95

Heartland Value (HRTVX)

1.10

5.60

ICON Utilities S (ICTUX)

1.35

6.50

Only one of these 5 funds beat the after-tax return on the S&P 500, although the majority of their pre-tax returns would have put them ahead or in close contention.

Funds that tend to have above average distributions, often as a result of high portfolio buying and selling, and high dividend distributions as a result of short-term trading, tend to underperform after they distribute these taxable gains to their investors.

Model Bond Portfolio Tax Analysis

Bond funds can, at times, generate higher tax costs than stock funds because much of their returns come from dividends. Further, these dividends are typically taxed at higher rates than dividend and capital gain distributions from stock funds which are usually taxed at more favorable rates, often at only 15%.

Suppose, for example, you have $10,000 in a bond fund and it reports a return for a given year of 4% of which 3% is from dividends, the remainder from undistributed price appreciation. You will have to report the $300 dividend distribution. Assuming that you are in the 28% Federal tax bracket, this will result in a tax liability of $84 ($10,000 x .03 x .28).





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Mar 2014

Without the distribution, your "net worth" as reflected in the account would appear to have increased by $400. But since you have to pay $84 more in taxes (although perhaps not out of the same account), your gain is actually reduced to $316 (400 - 84). Thus, post-taxes, your return is reduced from 4% to 3.16%. Effectively, you have lost 21% of your return to taxes.

Now let's look at approximately how much you would have lost to taxes for each of the funds in my current Model Bond Portfolio over the last 10 years.

Jan. '14 Model Bond Fund Portfolio

Annual
Tax Cost

10 Year Annualized
Return (Approx.) After Taxes
(Thru Feb 25, 2014)

PIMCO Total Return Instit (PTTRX)

1.55%

4.50%

Harbor Bond Fund (HABDX)

1.40

4.25

PIMCO Real Return (PRRIX)

1.40

3.80

Harbor Real Return (HARRX)

1.20

3.75

Vanguard Intermed. Term Tax-Ex. (VWITX)

0.0

3.90

Loomis Sayles Retail (LSBRX)

1.70

6.05

Fidelity High Income (SPHIX)

2.00

6.00

PIMCO Foreign Bond (USD-Hedged) Adm (PFRAX)

1.55

4.45

Note: Harbor Real Return has not been in existence for the 10 full years; results shown are estimates based on available information for life of the fund.

If you compare the above figures to that for two funds that are often considered the benchmark indexes for bond funds, VBMFX and AGG, as shown below, you find that both of these lost a little more than 1% each year to taxes. Thus, based on tax-efficiency alone, it might seem that you would better off choosing these index funds than almost all of our Model Bond Portfolio funds.

Benchmark Bond Funds

Annual
Tax Cost

10 Year Annualized
Return (Approx.) After Taxes
(Thru Feb 25, 2014)

Vanguard Total Bond Market Index (VBMFX)

1.15%

3.30%

iShares Core Total Aggregate US Bond (AGG)

1.05

3.25

But, of course, if our Model Bond Portfolio funds were able to outperform the benchmark funds even after deducting costs for taxes, they would still be a better choice. As you can see, this is indeed the case for each of our 8 Model funds.

You might also note that the after-tax return of the bond ETF was essentially the same as for the tax-efficient fund, VBMFX. As with the comparisons of several highly tax-efficient S&P 500 stock funds with their comparable ETF shown above, this throws a little cold water on the argument that ETFs are always to be preferred to nearly identical non-ETF funds.

Finally, let's also look at the comparable data from a few mediocre performing bond funds especially on an after-tax basis. There was no other particular reason for picking these specific funds.

Bond Funds that Lag on an After-Tax Basis

Annual
Tax Cost

10 Year Annualized
Return (Approx.) After Taxes
(Thru Feb 25, 2014)

Highland Fixed Income Y (HFBYX)

1.10%

3.00%

Metropolitan West Strategic Income M (MWSTX)

1.90

1.90

BNY Mellon Bond M (MPBFX)

1.20

3.15

Northern US Government (NOUGX)

1.05

2.05

Federated Income Service (FITSX)

1.15

2.60



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Mar 2014

While all but one of these funds (MWSTX) have tax-related costs pretty much in line with the benchmark funds, and as good or better than our Model Bond Portfolio funds, none of them averages particularly outstanding performance after taxes. Nor are the expense ratios charged by these funds much different than our Model funds, except also for MWSTX.

While it is hard to draw generalizations based on just a few funds, the data seem to suggest that if you can find a bond manager with a long-term track record of pre- and after-tax outperformance, he/she is probably the one you should select even if the fund's tax-efficiency and expense ratio is higher than that of a lower cost alternative.

Important Implications

The above data argues for selecting funds for your taxable account that will give you the highest after-tax return as opposed to what might be a higher pre-tax return. These higher pre-tax funds might be those that trade a lot (i.e. have a high turnover) or do not manage the fund in a particularly tax-efficient way, such as by generating many high tax short-term gains as opposed to mainly seeking lower taxed long-term gains.

Investors interested in seeing the tax efficiency of any particular fund/ETF they own or are considering buying should make use of the free data on the Morningstar.com website. To access it, go to the site and enter the fund code in the "Quote" entry box. When the fund's data page is displayed, look for the "Tax" tab under the fund name. Upon selected it, you will see data for the fund's annual "Tax Cost Ratio." Keep in mind, though, that this data is calculated under the assumption that the investor is paying taxes at the highest Federal rate which recently could be as high as 43.4% for some dividends and 23.8% for capital gains. Most investors will not have such high rates, and so therefore, their tax costs are somewhat lower than shown.

While what appears to be a relatively small difference in tax cost, say 1.40% for a stock fund as compared to one of 0.40%, such a small yearly difference can add up tremendously over the years.

Suppose you find that these two funds both have shown total returns (pre-tax) of about 9% per year over the last 20 years. The fund with a tax cost of 1.40% has an after-tax return of 7.6% while the 2nd fund will have one of 8.6%. How much difference can that really make on a $25,000 investment held for 20 years?

Actually, the fund with the higher tax cost will be worth $108,190 after 20 years. The fund with the lower tax cost will be worth $130,178, or a $21,988 difference. Clearly, when picking funds with equal pre-tax performance records, you are much better off choosing one that loses less to taxes each year. But the data also show that some funds may still enable you to come out ahead in the end even if they have higher associated taxes each year, as our analyses above show.

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End of How Much of Your Investment Return Are You Losing to Taxes?

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Return to Page 1 if you haven't already read Selling a Fund? Don't Overpay on Your Taxes













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Mar 2014

(Selling a Fund? Don't Overpay on Your Taxes, continued from page 1)

could come about by being unaware of a misinterpretation of IRS rules for correctly figuring the amount of your capital gain. And this is exactly what I discovered upon examining information provided by previously reliable sources of tax advice. This includes mutual fund companies themselves or tax experts who provide information on their own websites who are incorrectly interpreting requirements for fund companies and assuming the same requirements are true for fund investors.

Say on 08/08/2011, you bought 1000 shares of a fund; we'll use Vanguard U.S. Value Fund (VUVLX) in this example, but the problem would be the same regardless of the fund. On that date, the price was $9.00 per share. If you purchased no other shares before your sale, your cost (or in more technical terms, your cost basis) which you must know when figuring your gain or loss when sales are reported) is $9000 (1000 shares x $9).

Most investors choose to reinvest their dividends and capital gain distributions in new shares. So, on 12/16/2011, when you received a dividend of approximately $218, more shares, exactly 22.154 more, were automatically purchased at 9.84 per share ($218 / 9.84 = 22.154)

To figure their cost basis, most investors take the average cost of all of their shares. So, with this new purchase they now own a total of 1022.154 shares at an average cost of $9.02 per share ($9218 total invested divided by the total number of shares).

In this example, the following chart shows your activity history and average cost basis calculations through the end of 2013:

Example Showing How to Determine Your Average Cost Basis
for Shares Sold After Jan. 1, 2012
Date Shares Bought/
Sold
Price
Per Share
Total Paid/
Received
Total
Cost
Cumulative
Shares
Cost Basis
per Share
08/08/2011 1000 $9.00 $9000 $9000 1000 $9.00
12/16/2011 22.154 $9.84 $218 $9218 1022.154 $9.02
10/18/2012 1000 $12.13 $12130 $21348 2022.154 $10.56
12/17/2012 49.446 $11.86 $586.43 $21934 2071.6 $10.59
12/17/2013 39.891 $15.06 $600.76 $22535 2111.491 $10.67
12/31/2013 - 1000 $15.59 $15590 $11860 1111.491 $10.67

It would appear that your average cost basis for all your shares, and, particularly for those sold would be $10.67. Since you sold 1000 shares at 15.59, your gain should be 15.59 minus 10.67 or $4.92 per share sold, or in total, $4920 (1000 shares sold x $4.92 gain).

However, according to TurboTax Deluxe software as well as your unofficial year-end tax report from Vanguard, you would instead be shown a different cost basis, one that if simply accepted as valid, would result in a considerably higher tax due.

Why this is true is complicated to explain. Briefly, for shares purchased beginning Jan. 1, 2012, mutual fund companies are required to keep track of and report your cost basis whenever these particular shares are sold. For shares purchased before Jan. 1, 2012, a different cost basis is applied which usually would entail averaging just the cost of such pre-2012 shares separately.

Unfortunately, though, whenever such pre-2012 shares are sold, as in the above example, fund companies such as Vanguard and T. Rowe Price have been apparently instructed by the IRS to show the cost basis as computed from the pre-2012 shares only. In this example, therefore, the cost basis would be shown to be $9.02 although this figure would not be sent to the IRS.

If one uses the 9.02 figure in this example, the capital gain would seem to be considerably higher. Specifically, your sale gain would be 15.59 minus 9.02 or $6.57 per share sold, or $6570 in total.

The result: You now have two different figures, $4920 and $6570, each of which represents the long-term gain you are required report on your taxes. But which is correct?

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Readers should be advised that I am not a tax expert. However, according to the 2013 IRS publication that explains in detail how to figure your capital gains and losses for mutual funds using average cost, Publication 550, you should add up all purchases and reinvestments regardless of whether they were purchased before 2012 or later to arrive at your average cost (for those so inclined, a detailed example of doing that is shown on pages 46 and 47 of that publication).

Therefore, regardless of the gain reported by your mutual fund company, TurboTax, or even your own tax preparer, you should check to see that any capital gain reported using average cost actually uses the average of all shares purchased, not just shares you may have purchased prior to 2012. Since stock prices (and some bond) prices have risen considerably for long-term share holders over the last 2 years, any additional purchases made since Jan. 1, 2012 are likely to have raised your average cost basis. The more purchases made at higher prices, the higher your cost basis for shares purchased prior to 2012 will become. This means that any subsequent sales with capital gains, either in 2012, 2013, or at any time in the future should reflect a higher cost basis meaning lowered capital gains.

Note: Even if you made no sales after Jan. 1, 2012, you may want to retain this month's Newsletter for future reference. The more shares you have purchased after this date (either through re-investment or your own new purchases), and assuming stock (and possibly bond) fund prices keep moving higher, the more you stand to lose by using the improper pre-2012 average cost basis only in computing your capital gain.

Since I am not a tax professional, I advise you to either see the above example in Publication 550 available online, or to check with your tax preparer before submitting your tax forms if you have sold some shares of a fund in 2013, or when you do in the future.

And, if any reader is tax professional or has encountered this problem and wishes to add to what I have reported here, please do and I will update this information for all readers to see.

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