Taxes and the Investor

Each year, mutual funds distribute to their shareholders all dividends and interest from their net investment income. They also distribute any net realized capital gains, classified as short-term capital gains and long- term capital gains. Funds cannot distribute losses ”instead they net them against their gains, either for the current year or in future years when they carry such losses forward. Funds send their shareholders a Form 1099-DIV which tells them the earnings to report on their income tax returns, classified as ordinary dividends and capital gains distributions.

• Dividends. Dividends paid by a mutual fund are taxed as ordinary income for the shareholder. This will also be true for the ETFs considered in a later chapter. It is net income after fund expenses that is taxable to the shareholder.

• Interest. Interest paid by a mutual fund is taxed similarly to dividends. It is net interest income after fund expenses that is taxable.

• Capital gains. A mutual fund generates capital gains whenever it sells securities in its portfolio. The mutual fund generally passes these capital gains and losses on to shareholders, classified as short-term and long-term, and the investor pays taxes at the appropriate tax rate. If gains are short term, they are taxed at the investor's marginal tax rate, which can approach 40 percent. If they are long term, the gains are taxed at the long-term capital gains rate of 20 percent.

  We are talking here about realized capital gains: shares have been sold and gains have been realized. They might not yet be distributed, but the fund has realized the gains, and they will be distributed. In contrast, a fund can have substantial unrealized capital gains, meaning that the prices of some of their securities have gone up, and if they were to sell the shares they would have a realized capital gain.

  Shareholders must also pay taxes when they sell their shares of the mutual fund. The capital gain is the difference between the amount received in the sale and the investor's cost basis on the shares sold.

  We have noted before that Morningstar is a valuable source of information for mutual fund investors. By going to their Web site and looking at a particular fund, you can see for that fund a number calculated by Morningstar called Potential Capital Gains Exposure (PCGE). This number tells investors how much of a fund's total assets are attributable to capital appreciation , and therefore could be subject to taxes if the positions are sold. Note, however, that the positions must be sold to generate realized capital gains.

  If a fund has a high PCGE, it could indicate a potentially large tax liability. However, the fund has to turn the positions into realized capital gains. Some funds are quite good at not doing so. Conversely, a fund can show a negative PCGE. This suggests some protection for investors because some gains can be realized without generating a taxable event for them. However, the protection might not be as strong as it first appears. The stocks in the portfolio can turn around quickly, which reduces the size of the negative PCGE and the unrealized losses can possibly become unrealized gains.

  In early 2002 the Nicholas-Applegate Global Technology Fund had a PCGE of “580 percent, a startling number indeed. At first glance you might decide this fund won't be making taxable capital gains distributions any time soon. However, as we all know by now, technology is a volatile sector, and it is conceivable that the stocks in this portfolio could turn around quickly and reduce the negative PCGE substantially.

  Furthermore, as new money flows into the fund, the fund's negative potential capital gains exposure ”which is stated as a percentage of its assets ”is also reduced. Because the Nicholas-Applegate fund had only about $58 million of assets when this PCGE was reported , substantial new cash flows could have a large impact.