One important difference between managed accounts and mutual funds is their handling of capital gains. Mutual funds distribute gains to the people who own the fund at the end of the year. Many investors find that in years when their mutual fund holdings decline in value they still receive taxable capital-gains distributions from the fund. They lost money, but still had to pay taxes. In a managed account, however, you only get taxed on the gains you actually receive.
Most mutual funds make an annual distribution of their capital gains. This distribution usually occurs late in the year and reflects any net capital gains incurred due to the year’s activity. Funds that have both long-term and short-term gains will issue two distributions, one of each. Under the accounting rules funds must follow, these gains are applied to all shareholders as of a certain date. For this reason it is possible for you to own a fund for only a few weeks and get hit with capital gains tax on transactions that occurred early in the year — before you even bought the fund.
According to one recent study, the average equity mutual fund loses more than 2½ percentage points of its return to taxes each year.1 This means that a fund with a pre-tax return of 9 percent may return of less than 7 percent after taxes. Over time this can make a huge difference to your wealth. Because of this, the SEC now requires all funds to list after-tax returns in their prospectuses.
Because this year was so volatile, some experts fear that distributions will be particularly high. “Some fund experts predict this year’s total mutual-fund distributions will be the highest ever. Despite the summer market turmoil, stocks have moved substantially higher this year, creating sizable gains in many funds. A number of funds have also exhausted their supply of losses booked during the last bear market, which they’ve used to offset gains in recent years.”2
Conversely, money managers buy and sell securities throughout the year and incur gains or losses on those sales, but you only get taxed on any net gains that actually occurred in your account during the tax year. Also, near the end of the year you may be able to instruct your manager to take tax losses on positions that have an unrealized loss to offset gains in the account. This strategy is called tax loss harvesting. It involves temporarily moving out of a position in order to satisfy the requirements for deducting the loss. Then the position is repurchased. This can be a useful strategy, but it must be done correctly and is not without its own risks.
1KPMG Peat Marwick LLP, An Educational Analysis of Tax-Managed Mutual Funds and the Taxable Investor.
2Taxable Payouts On Many Funds Are Set to Surge, Wall Street Journal, October 24, 2007.