FOCUS ON AFTERTAX RETURNS FROM NONRETIREMENT INVESTMENTS IN MUTUAL EQUITY FUNDS

By Lawrence R. Hudack, and Duane M. Ponko

Year-end tax planning should include a careful examination of nonretirement investments in mutual equity funds, especially for the more affluent investors. More specifically: Are these equity funds earning the best aftertax returns? What changes, if any, should be made to these investments in order to take advantage of the lowest Federal income tax rates on capital gains? Furthermore, is it too late to take advantage of the lowest tax rates, if changes to an investment portfolio are determined to be appropriate?

Since most funds make their distributions in early December, investors have until then to alter portfolios and thereby be eligible to earn the highest aftertax returns for the current year. The two types of aftertax returns that investors should monitor are current cash flow and overall posttax returns.

Why Is the Type of Income Important?

The Taxpayer Relief Act of 1987 as amended by the Tax Reform and Restructuring Act of 1998 motivates investors and their CPA financial planners to consider an additional criterion in order to maximize aftertax returns from mutual funds. The typical focus on risk and return should be expanded to consider the impact of taxes for virtually all investors, regardless of their income tax bracket. Any capital gain with a holding period exceeding 12 months is taxed at significantly lower rates for virtually all taxpayers. The only exception is for those taxpayers that are subject to the alternative minimum tax.

The Taxpayer Relief Act lowers the Federal capital gains tax rate on investments that are held for more than 12 months to 20% (from 28%) for taxpayers with Federal marginal tax rates (MTR) between 28% through 39.6%. Furthermore, taxpayers with a Federal MTR of 15% can qualify for the new 10% maximum capital gains tax rate. The former is relevant to affluent investors, while the latter may be noteworthy for senior citizens.

Prior to the recent change, only taxpayers in the higher Federal income tax brackets (with Federal MTRs equal to 31% or higher) received a tax break for long-term capital gains (i.e., the maximum tax rate was 28%). The vast majority of taxpayers (15% and 28% Federal MTRs) did not have to be concerned with the holding period of a capital gain, since their rates were equal to or lower than the 28% maximum rate. It is therefore now relevant for all investors to understand the type of mutual equity fund that receives preferential treatment from the Federal tax law.

Are Index Funds Better?

Conventional wisdom favors an index fund over an actively managed mutual fund for a nonretirement investment account, especially over the past three calendar years. The type of income generated and distributed by a fund can result in a substantial difference in income taxes due. A higher pretax return may result in a lower aftertax return when comparing an actively managed fund to a passive index fund. An actively managed fund normally has a relatively high portfolio turnover ratio (i.e., approaching or exceeding 100%) because of the perpetual process of buying and selling the stocks. In contrast, an equity index fund normally holds stocks representative of a particular market niche (e.g., the S&P 500). The typical long holding period of an index fund should enable the investor to qualify for the lowest capital gain tax rates.

But, does this mean that investors should automatically switch to index funds? To answer the question, we examined the most recent year ended to gather relevant, empirical data. This investigation examines two highly regarded mutual equity funds and interprets the evidence to support or contradict the conventional wisdom.

Selection of Benchmark and Alternative Funds

Numerous equity funds have reported very appealing pretax returns during the past three calendar years. We chose the Vanguard Index 500 to be our benchmark fund. We used Morningstar Principia (December 31, 1997) to identify an alternative fund; the primary selection criteria were a higher pretax return than the index fund, total assets of at least $1 billion, a high portfolio turnover (close to 100%), and a Morningstar rating of at least 4 (out of 5) stars. With the above criteria in mind, we chose the American Century Income and Growth fund.

Section I of the Exhibit reports the background data for the two funds. The Vanguard Index 500 fund earned the 59th highest pretax return (33.21%) out of 610 growth and income funds for 1997. The American Century Income and Growth fund earned an impressive 37th highest pretax return (34.29%) for 1997. The American Century Income and Growth fund was more aggressively managed with a portfolio turnover of 92% compared to the Vanguard 500's five percent. The better pretax return is attributed to the selection criteria, especially with respect to fund size and portfolio turnover.

The next step was to obtain important data not available in published documents. The aftertax return depends upon the type of income generated by an investment. The critical factor is the amount of taxable distributions by the mutual fund. Mutual funds are required to distribute all dividends received and realized capital gains within 12 months; otherwise, the fund is subject to Federal taxes.

The types of income generated by each fund were determined by calling the fund families' toll-free phone numbers and requesting a detailed analysis of total distributions on a per share basis. Current investors can simply refer to last year's form 1099s (if the funds have been owned since December 1997). The type of income per share is necessary to calculate the five components for each fund's pretax return.

The percentages of return are calculated through a two-step process. First, the yield per share for each type of income is calculated by taking the specific type of distribution (or increase in net asset value, NAV) and dividing by the NAV as of January 1, 1997. Second, the respective yields are divided by the total pretax return. The percentages of return are an integral component of the pretax to posttax conversion formula.

Section II of the Exhibit illustrates the types of income generated by the alternative (American Century Income and Growth) and benchmark (Vanguard Index 500) growth and income funds for 1997. American Century's more aggressive management style is reflected in the higher portions of the currently taxable distributions (e.g., realized capital gain distributions of 19.82% short-term, 13.31% long-term). In contrast, Vanguard's passive approach means that most of its pretax return (91.64%) is from an undistributed increase in NAV (i.e., an unrealized gain that is a deferred tax item). This scenario offers preliminary evidence in support of the conventional wisdom. To come to a more definitive judgment, a more thorough investigation using various MTRs to calculate aftertax returns should be performed.

What Do the Aftertax Returns Suggest?

A mutual equity fund's aftertax return can be defined as either an immediate (current cash flow) or a more inclusive (long-term overall) posttax return. The current cash flow return is the pretax return reduced by the current income tax obligation, i.e., income taxes that are related to distributions of dividends and capital gains by the fund. The long-term overall posttax return is the pretax return reduced by both the current income tax obligation and any projected (deferred) income taxes, i.e., income taxes that are related to the undistributed increase in a fund's NAV.

Section III of the Exhibit reports the two types of posttax returns for the benchmark and alternative funds: current cash flow aftertax return and overall aftertax return for all three potential holding periods of the fund. The current cash flow aftertax return by the benchmark fund is greater than the alternative fund's return for all investors. This is strong evidence for conventional wisdom, despite the fact that the pretax return for the American Century fund is 1.08% higher than the Vanguard fund. The lower pretax earnings produced a higher immediate aftertax return for all MTRs! The index fund's current year tax efficiency score was 97%, while the alternative fund's score was 88% or lower for all investors (except for the lowest MTR of 19%). The overall posttax returns also support conventional wisdom if the fund is held over 12 months for MTRs of 35.73% or greater; the higher pretax returns by the alternative fund produced lower aftertax returns. Meanwhile, if the funds are held less than 12 months or the MTRs are less than 35.73%, then the evidence is contrary to conventional wisdom.

Closing Comments and Suggestions

There is rarely, if ever, a clear-cut choice when making a complex financial decision. Our primary suggestion is that the investor should gather relevant information about past performance, specifically the aftertax returns for equity funds held in nonretirement investment accounts, in order to make informed decisions about future investment strategies. Hence, investors should know both the current cash flow aftertax return and overall aftertax returns from their investments. The overall aftertax return includes both current and deferred income taxes.

In our opinion, the results are mixed. A strong bull market favors index funds; they have outperformed most of the aggressively managed equity funds over the past three calendar years. Yet, if clients have a higher tolerance for risk (and of course, invest in the right fund), then the higher returns from actively managed funds can offset the tax advantage afforded to index funds even in the best of markets.

Past history shows that, in a bear market, alternative funds are more likely to either outperform or underperform index funds. Hence, the less than phenomenal pretax returns of index funds in a bear market might cause conventional wisdom to be cast aside in favor of the potential of more aggressively managed funds. Any informed decision to move away from the index funds must consider the higher income tax consequences. *

Lawrence R. Hudack, PhD, CPA, is an associate professor of accounting at Barry University. Duane M. Ponko, CPA, is an assistant professor of accounting at Indiana University of Pennsylvania. The authors gratefully acknowledge the assistance of Carol Fisher and Fred Ding in the writing of this article.

Editors:
Milton Miller, CPA
Consultant

William Bregman, CPA/PFS

Contributing Editors:
Alan J. Straus, CPA
Own Account