Feds put bite on after-tax fund reporting

Federal regulators are finalizing proposals that would make it easier for investors to figure out the tax bite on their mutual fund returns.

The proposed changes would require fund companies to start reporting after-tax performance along with pre-tax returns for periods of one, five and 10 years, or the life of the fund.

The idea is to create a calculation that will allow investors to make it easier to compare fund results.

“When you look at the numbers of taxable distributions that are being paid out by funds and how it can impact and reduce return over time, the numbers are pretty significant,” says Paul Roye, director of the Securities and Exchange Commission’s division of investment management, which oversees mutual funds.

SEC commissioners will discuss the after-tax reporting rules March 15. If the proposals are approved, the commission will solicit public comments for 30 to 90 days before adopting rules.

“We’ve tried to come up with a formulation that makes assumptions to give investors some indication of what the tax impact will be,” says Mr. Roye. “It’s not going to be something that you will look at and say this is exactly what my return would have been. But it will give you some indication as to how taxes can reduce your performance,” he adds.

SEC employees are expected to recommend that after-tax returns be reported two ways.

One will show net return for investors who keep their fund shares — reflecting taxes on dividends and capital gain distributions.

The other will show the net return to an investor after selling an investment and paying any capital gains taxes and fund exit fees.

The agency estimates that stock and bond fund shareholders paid $34 billion in taxes on fund distributions in 1997.

Federal taxes on dividend and capital gain distributions chew up nearly 21/2 percentage points of the average U.S. stock fund’s return each year and as much as 71/2 percentage points on the hardest-hit funds, according to a study by Vanguard Group of Malvern, Pa.

already reporting

At least four fund sponsors — Charles Schwab Corp., Eaton Vance Corp., Fidelity Investments and Vanguard — are already reporting after-tax returns for some or all of their stock funds.

And other fund groups are joining in. In April, Liberty Financial Co.’s Stein Roe & Farnham Inc. fund unit will include after-tax performance returns in the semi-annual shareholder reports of its two tax-managed growth and value funds.

Until last year, most fund companies only reported after-tax returns for funds that were specifically managed to minimize taxes. But since October, Vanguard, Schwab and Fidelity have expanded their after-tax return reports to include all of their equity funds.

In addition, Schwab and Fidelity now provide after-tax returns via their websites for most stock funds sold through their mutual fund supermarkets.

All four fund companies now reporting after-tax returns use the top federal tax rates that were in effect at the time of the distribution.

Currently they are 39.6% for dividends and short-term capital gains and 20% for capital gains on securities held longer than 12 months.

Like the SEC proposal due next month, none of the companies make adjustments for state or local income taxes in fund shareholder reports.

But there are differences in how the fund sponsors report the tax hit. Fidelity reports after-tax returns for both buy-and-hold investors and under a scenario that assumes an investor sells a position at the end of the measurement period.

Eaton Vance, Vanguard and Schwab report the tax impact only for buy-and-hold investors. They say the approach best helps explain how a fund manager’s investment decisions affect the after-tax returns received by shareholders.

Fidelity says it includes the post-liquidation value because it reflects the reality that taxes can’t be deferred indefinitely.

Still unaddressed in the SEC after-tax reporting proposal is what tax rate will be used to figure taxes on dividends and short-term capital gains.

“If you are going to err one way or the other, you’re better off using the higher tax bracket,” says a Vanguard spokesman. “It may overstate the tax effect, but no one is harmed by it.”

The Investment Company Institute, the mutual fund trade group, urged the SEC to consider using a lower tax rate on fund distributions, if the rule is applied to all stock funds.

Otherwise, the top 39.6% federal rate would overstate the tax effect for the median mutual fund investor, who earns $55,000 annually.