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Are Funds Worth The Yearly Tax Bite?

BusinessWeek Investor -- The Barker Portfolio

Are Funds Worth the Yearly Tax Bite?

The way most stock funds have gone up over the past few years, they've been awfully hard to hate. Except right now. Not only have most of my funds started the new year on a downer but my mailman keeps bringing me 1099-DIV forms heralding taxes I'll soon owe on my funds' capital-gains distributions. These taxes shouldn't shock me, but they do, every year. And I know I've got plenty of company. Bob Santoro, Charles Schwab's Vero Beach (Fla.) branch manager, told me he soon expects to see upset fundholders with 1099s "lining up out the door."

If you own mutual funds in a taxable account, you've learned about this the hard way. Tax rules make funds pay out to investors net capital gains realized in their portfolios. You're taxed on them even if you don't sell a single fund share. Hold stock directly, on the other hand, and you see no capital gain--or tax bill--until you sell. You control how much gain to take and when.

This year, I decided to see where I might stand had I bought and held stocks instead of funds. I penciled my way through two scenarios, each covering the four years that ended on Dec. 31 (table). In the first, I imagined having split $100,000 evenly between two good funds, a growth-stock mutual called Harbor Capital Appreciation and a value fund, Dodge & Cox Stock. (I actually own some of both--just not so much.) Second, I imagined having built a stock portfolio, putting $10,000 in each of those funds' top five holdings, as disclosed in what had been the funds' latest reports. Next, from Morningstar's database, I figured out each portfolio's value after four years, how much in taxes and fees I would've paid along the way, and how big my potential capital-gains tax would be.

This unscientific experiment would no doubt set a finance professor's eyebrow twitching. Yet to me, it had this virtue: It's just the sort of choice thoughtful individuals ponder when trying to put a lump sum to work in the stock market. My results? Surprisingly, despite the constant drag of operating expenses and fees, the fund portfolio returned more, before taxes, than the 10 individual stocks. Other stocks and other funds would have performed differently, of course. Yet when I looked closely, I did come to appreciate how active management of these funds had helped. One stock from Harbor, LSI Logic, fell from the fund's top 10 list within two months. Good move: It proved to be worst of the five I drew from Harbor. Ditto with the worst from Dodge, Digital Equipment, which the fund wisely booted in 1998. Now the bad news: After four years' worth of capital-gains taxes on the funds, owning stocks looks a lot better--$3,890 better.

It's true, as Vanguard Group fund-taxation expert Joel Dickson told me, that the stock portfolio's tax bill didn't disappear. It just hasn't come due yet. He also noted that owning only 10 stocks was probably a lot riskier than owning shares in two diversified funds, and that many index funds succeed in minimizing capital-gains distributions and taxes. He's right on all counts. Yet clearly, a buy-and-hold investor also pays a price for diversifying via funds: control over when to pay Uncle Sam. Play your cards right and some capital-gains bills can disappear, either because they're offset by other losses, they're forgiven if you give stock to charity or, if you plan on leaving your stocks to heirs, they get zapped by estate-tax rules. What is worse, once you pay a capital-gains tax on fund payouts, either by selling some fund shares earlier than you might have planned on or by tapping a separate pool of money, you've lost capital that might have been invested: annual-return compounding on annual return.

What should you make of all this? Neither funds nor stocks are always superior for everyone. But the more money you have with which to build a diversified stock portfolio, and the longer you're able to put off capital-gains taxes, the less likely you'll find yourself hating your investments this time every year.Questions? Comments? Send an e-mail or fax (321) 728-1711By Robert BarkerReturn to top

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