Some Mutual Funds Win in Tax Game

Critics lambaste mutual funds, calling them old-fashioned contraptions that generate big tax bills. It's true, on average, that exchange-traded funds and separate accounts have tax advantages over mutual funds, data from Morningstar and other sources show. But advisors shouldn't dismiss mutual funds too quickly.

To appreciate how close the race is, compare the returns of competing ETFs and open-end index funds that track the Standard & Poor's 500. The two largest ETFs in the category, SPDR Trust Series I and iShares S&P 500, both post 0.58 tax-cost ratios. But traditional index funds run by Fidelity, Schwab and Vanguard actually do better on a tax-cost basis in this category. The winner in the group is the Vanguard 500 Index with a tax-cost ratio of 0.41.

How does Vanguard foil the tax man? When the fund must sell stock to raise cash for redemptions, the managers are careful to dump shares that cost the most to purchase. In addition, Vanguard takes advantage of provisions that came with the 2003 tax legislation. Under the law, stock dividends can be taxed at a maximum rate of 15 percent. But to qualify for the low rate, an investor must hold the shares for at least 61 days during the 120 days that come before and after the dividend. Otherwise, that tax rate rises to 35 percent. As a buy-and-hold investor, Vanguard nearly always qualifies for the lower tax rate.

In contrast, ETFs sometimes stumble over the tax law. Investors buying an ETF usually swap the actual stocks in the ETF for shares in the ETF. So whenever the iShares fund rebalances, it may sell some stocks before the 61-day holding period is over. That means dividends will face the 35 percent tax rate.

Just as they sometimes outdo ETFs, mutual funds can often best separate accounts. In a separate account, an investor owns individual stocks. But in the typical mutual fund, the investor owns shares in the total portfolio, and thus can end up owing capital gains taxes on stocks that rose in value long before he bought shares in the fund.

Still, just as funds can build up unrealized gains, they can accumulate losses over the years. For example, according to Morningstar, the average mid-cap growth fund has embedded losses equal to 16 percent of assets. While someone who invests in a separate account starts with a clean tax slate, some new fund investors have an edge — substantial protection against capital gains tax bills.