The tax bite of top mutual funds

December 20, 2012: 11:48 AM ET

Some of the best mutual funds of year can generate huge tax bills, wiping out returns.

By Scott Cendrowski

121220041822-tax-nightmare-gallery-horizontalFORTUNE -- It's the time when "Best funds of the year" lists start appearing in newspapers and glossy magazines. You might even be tempted to dump your portfolio's funds and replace them with these best-performers.

Slow down. Not only do you want to avoid chasing the hot fund of the moment, but you might want to see if the tax bill on some of these all-stars is so high that it strips you of much of the return you think you've earned. You're responsible for paying taxes on a fund's gains. But what fund rankings never tell you is what you'd owe Uncle Sam if you held the top performers.

The problem arises in funds with high turnover because all that buying and selling generates short-term capital gains taxed as ordinary income, a rate that climbs as high as 35%. The tax bill is also exacerbated when the same high-turnover fund relies on dividend payments, which are taxed at up to 35% for stocks held for only brief periods. This isn't a problem for investors who own funds in tax-deferred accounts, such as 401(k)s and IRAs. But if you're holding funds in a regular account, you want to pay attention.

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Some popular PIMCO funds offer a cautionary tale. Bond guru Bill Gross runs PIMCO's StocksPLUS Total Return fund (PSPTX), an index fund that tracks the S&P 500 using derivatives to juice returns. Morningstar ranks the fund as the sixth best performing active U.S. stock fund of the past year (ending Nov. 30). But once you consider the taxes you'd pay owning it, the fund gets dropped from the top ten. Its one-year return falls from 28.75% to 26.41% after taxes.

Still, not bad. Only two percentage points of gains are eaten up.

But look what happens over a slightly longer period. Gross runs another fund, PIMCO's Fundamental IndexPLUS Total Return fund (PIXAX). The fund's 19.9% annualized return over the past three years is reduced to just 7.24% annualized after adjusting for taxes. That's 12 percentage points of return lost to Uncle Sam each year. Big money.

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When you pay taxes on high quarterly distributions from a fund, you reduce the amount of money you can reinvest. You're hampered from fully compounding your investment, a huge component of returns. That's the case in these PIMCO funds. For comparison, the Vanguard 500 Index Admiral (VFIAX) shares, an S&P 500 index fund, posted a three year annualized return of 11.23%, which only falls to 10.88% after taxes.

Thanks to Morningstar, we have a ranking of top 2012 funds after taxes (year ending Nov. 30). First, the top 10 funds according to pre-tax returns.

chart 1

Now look at the returns after accounting for taxes. PIMCO's StocksPLUS fund (PSPTX) drops off the list entirely and many funds lose a couple points of return even over the short one-year period. (The tax effect is much larger over a longer holding period like three or five years.)

chart 2

Here's one last ranking. This time, a list of funds that generated the highest tax bill for investors over the past year. We show their total return, and the return lost to taxes. (This assumes you bought the funds last November and held them through the end of this November.)

chart 3

Remember: taxes are one more reason you should think twice before buying high-flying funds.

Follow Scott Cendrowski on Twitter, @scendrowski.

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