Discover Tax Gains in Tech Fund Losses

Physician's Money Digest, October 2005, Volume 12, Issue 14

BusinessWeek

The age-old expression every cloud has its silverlining offers an optimistic view of life and theworld in which we live; if there are positives tobe gained from a situation, make the best of them. Inthe case of mutual funds and their investors, the technologybust that clouded the landscape for manyfunds several years ago has a silver lining all its own.And according to a recent report, that'sdefinitely good news for mutual fund investors.

Silver Lining Shines

When the market experienced a sharp decline in2000 and the tech bubble finally popped, a large numberof investors abandoned poor-performing funds,forcing fund managers to sell stocks at extremely lowprices and take big hits. Although it has been morethan 2 years since the market began to recover fromthe technology bust, Morningstar.com points out thatthe average domestic equity fund still has capital lossesin excess of 15% of its assets.

If mutual fund investors profit from a sale, capitalgains taxes are charged, just as when sellingstocks. According to the US tax code, mutual fundsmust pay out 98% of any capital gains they earnwhen selling stocks from their fund portfolio andphysician-investors are required to pay taxes onthose gains within the same year, whether or notthey continue to hold onto the fund. Capital losses,which impact both the stocks that the funds havesold as well as those still owned, are used by fundsto offset any future capital gains. What this meansis that as long as those capital losses last, mutualfund investors will be able to purchase certain fundsand avoid taxes on gains until they sell.

Maximize Tax Benefits

The funds with the deepest losses are those thatwere hit the hardest when the bubble burst: large-capgrowth and technology funds. Some of theleading funds in this category include Fidelity AggressiveGrowth, Vanguard US Growth, JanusMercury, and T. Rowe Price Science & Technology.Although the T. Rowe Price Science & Technologyfund cast off approximately 75% of its valuebetween 2000 and 2002, it still has $5.8 billionworth of losses.

The effects can also be long-lasting because capitallosses can be applied to future gains and carriedforward for up to 8 years. In the case of funds likeFidelity Aggressive Growth, whose losses won't expireuntil 2011, physician-investors could reap thebenefits of tax-free gains into the next decade.

Choose Funds Wisely

Of course, not every mutual fund offers this tax-deferredhaven. Value funds, especially those thatinvest in small companies, could make a distributionthis year because they have continued to performwell over the past 5 years. However, research firmLipper points out that mutual fund investors paidonly $1 billion in capital gains taxes last year, comparedwith $15 billion in 2000. So even if value fundsmake a distribution in 2005, physician-investors arenot likely to owe a great deal.

In addition, do not let taxes cloud your judgmentwhen it comes to making your investmentdecision. Physician-investors should also considerfactors such as fund expenses, performance, andstrategy. If a mutual fund is ranked near the bottomamong its peers, taking advantage of any taxbenefits may be negated by the fund's poor performance.