Pay Investment Taxes With a Smile

This is the season for gnashing of teeth. All of those lovely profits you earned in last year's robust stock market serve to increase your income taxes. Because many funds paid out capital-gains distributions, you may well end up writing a check to the IRS rather than receiving your customary refund.

It hurts like the dickens. Believe me, I know. In doing our taxes this year, we ended up with three roughly equal piles of taxable income: for myself, for my wife and for our investments.

But although it feels lousy to pay more taxes now, I think it's actually a good thing to do -- at least in most cases. Dubious? I don't blame you, but please read on.

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First off is the obvious. If you're paying taxes on your investments, it means you made money. But what about funds you didn't sell? It seems unfair to pay taxes on mutual fund distributions when you still own the fund. But I think capital-gains distributions -- which funds are required to make when they profit on sales of securities -- are really a well-disguised blessing.

Is there a way to escape those capital-gains taxes? As a matter of fact, yes. Mutual fund companies have spent years touting tax-managed funds, which are designed to pay out little or nothing in capital gains. Index funds and exchange-traded funds (ETFs) also make small capital-gains distributions.

But before you jump into one, look at the numbers. Joel Dickson, a tax efficiency expert at Vanguard, crunched the numbers for me. He assumed a 10% annual return, roughly the long-term average of the U.S. stock market. He assumed about 2% is paid out annually in dividends, about what you'd expect nowadays. The average tax-inefficient stock fund, Dickson says, distributes about 3% annually to investors in long-term capital gains and 1% in short-term capital gains. A perfectly tax-efficient stock fund, on the other hand, distributes nothing in capital gains.

So how does your after-tax income from a regular stock fund compare with that from a tax-efficient fund? If you sell after three years, the average period of time an investor holds a stock fund, the average stock fund grows from $10,000 to $12,742 after taxes. By contrast, the same money invested in the tax-efficient fund increases to $12,805. The difference comes to $63 -- enough for dinner out for yourself and your wife. Says Dickson: "Just picking a tax-efficient fund means nothing unless you're willing to hold it for the long term."

Five years isn't much better. The average fund grows to $15,004, while the tax-efficient fund appreciates to $15,158 after taxes-- a difference of $158. Go on a shopping spree at the supermarket.

These examples assume all shares are sold and all taxes are paid at the end of each period.

Only after ten years do you begin to notice some serious differences: $22,692 for the average fund compared with $23,354 for the tax-efficient fund. That's $662, enough for a decent television. Even so, the percentage difference in after-tax return isn't much: 8.85% annualized versus 8.54%.

After that, the power of compounding really picks up steam. Over 20 years, your investment will grow to $57,056 in the tax-efficient fund compared with $52,648 for the average fund. That's a $4,408 difference. The yearly difference in after-tax returns is still less than one-half of one percentage point, but the extra profit you've made from minimizing taxes provides some real money -- enough, say, for a great vacation overseas. (Of course, we're not taking inflation into account. Who knows what a trip to either Paris or the supermarket will cost many years from now?)

But here's the other factor you must consider: The federal tax rate on long-term capital gains and dividends is currently 15%. That's lower than it's been in many, many years. With the budget deficit mounting, I'd bet my '06 tax bill that long-term capital gains will rise not too long after President Bush leaves office -- no matter who replaces him. For a married couple filing jointly, the federal rate on short-term gains, currently 25% if your taxable income is between $61,300 and $123,700, may well rise, too.

Such an increase in tax rates could totally wipe out the advantages of tax-efficient funds. The way I look at it: Uncle Sam is holding a sale on capital gains -- take advantage of it. These rates won't last.

That doesn't mean tax-efficient funds are useless. For many well-to-do investors, index funds or ETFs that invest in Standard & Poor's 500-stock index or in the broader Dow Jones Wilshire 5000 index make a great deal of sense. They work especially well if you hold them for very long periods -- 20 or 30 years or longer. And if you hold to death, the tax hit will be minimal. The government is unlikely to eliminate the exemption from capital-gains taxes that your heirs get upon your death.

Meanwhile, write that check to the IRS with a smile -- it means your investments made some money last year. Happy April 17.

Steven T. Goldberg is an investment adviser and freelance writer.