WallStreet Journal
How to Share Less With Uncle Sam
Sunday January 6, 1:46 am ET
By Ian Salisbury


The year-end tax statements arriving from mutual-fund companies in the next few weeks could have fund investors facing the steepest capital-gains tax bills they've seen in years.

That's largely a reflection of years of good stock-market results, and it's now too late to trim the fund-related taxes you'll owe in April.

But with a new year under way, this is a good opportunity to think about being a more tax-efficient investor in the future.

Fund investors who hold shares in taxable accounts aren't just responsible for paying taxes on profits they earn when they sell fund shares. Uncle Sam also demands investors pay up on gains the funds make each year trading securities -- profits the funds are required to pay out annually to holders.

Usually, paying tax on those gains means you will owe less when you eventually sell your fund shares. But on the downside, funds' capital-gains distributions are taxable even if you don't get any cash and instead reinvest in additional fund shares.

Five years into the bull market that began in 2002, funds' capital-gains distributions in 2007 may end up exceeding the record $298 billion paid in 2000, the year the Internet bubble popped, according to Lipper analyst Tom Roseen.

The 2000 total is the highest Lipper has recorded since it began following the distributions in 1990.

Funds typically pass out large gains after they've had a long string of profits -- or after investors yank out money and the funds must sell holdings to raise cash to pay those who are departing.

Last year saw its share of both. It was the fifth straight year of respectable stock-market gains and also saw a shift in the kind of stocks investors favored, prompting outflows at many suddenly less popular "value" funds that focus on seemingly cheap stocks.

There's a further reason that fund investors could owe big tax bills this April: Steep stock-market declines in 2001 and 2002 helped keep tax bills low in 2003 and 2004, even as the market regained its footing, because funds could count their recent losses against new gains. By 2006, however, funds began to run out of stockpiled losses to offset their profits and such losses were even scarcer in 2007.

Here are some ideas on how to be a tax-smart fund investor:

He recommends funds that explicitly aim to avoid passing out capital gains, such as Vanguard Tax Managed International Fund (VTMGX), and those that have long done a good job of keeping them to a minimum, such as Third Avenue Value Fund (TAVFX).

Broad-based ETFs can do index funds one better. They have a special way of creating and eliminating fund shares that makes distributions even rarer.

What if you expect the securities to bounce back? You can't buy back your old investments for at least a month or the loss won't count for tax purposes.

Still, it turns out Uncle Sam is pretty flexible about what you can buy. You can replace one stock with another, swapping, say, ExxonMobil for Chevron. Over short periods, stocks of similar companies usually rise and fall together because they are subject to the same market trends.

Another option is buying a sector fund, such as the exchange-traded iShares Dow Jones U.S. Energy Sector Index Fund (IYE). ETFs can be more convenient than conventional mutual funds because they don't put any restrictions on investors buying and selling fund shares in quick succession.