For investors who own mutual funds in taxable accounts, December is the time to remember that it's not what you make, but what you keep.
Based on fund distributions in 2004, fund investors in taxable accounts paid an estimated $9.6 billion in taxes for that year, up 48 percent from what they paid in 2003, according to investment research firm Lipper.
Moreover, Lipper said its estimates are based on very conservative assumptions.
Taxes, it said, can reduce a fund investor's return by 1.8 to 2.5 percentage points - enough to turn decent returns into middling ones and so-so results into disappointments.
Over the long haul, Lipper said, taxes are a bigger drag on stock fund performance than management fees and commissions.
That's true despite the fact that 2003 tax cuts lightened the levy on capital gains and dividends.
"The tax drag is just a really big issue," said Tom Roseen, a Lipper senior research analyst. "People just don't have it on their radar screen yet and they really should."
When Eaton Vance, a Boston fund and investment manager, surveyed investors recently, 90 percent said taxes' impact is important to them.
"But they don't have a clue as to what to do about them," said Duncan Richardson, chief equity investment officer.
The Securities and Exchange Commission has been trying to raise investor awareness.
Since 2001, the federal regulator has required funds to disclose after-tax returns as well as the pretax returns featured so prominently in industry advertising.
One important point: Although after-tax returns are disclosed, most fund managers are compensated based on pretax returns.
Eaton Vance, T. Rowe Price, and other fund shops offer "tax-managed" or "tax-efficient" funds.
Assets in these funds totaled $42.3 billion as of Oct. 31, only about 1 percent of all the assets held in taxable fund accounts, according to Lipper.
The funds typically have low turnover, a measure of how often a stock or bond stays in a fund's portfolio.
A 100 percent turnover means a fund gets a complete facelift annually. A fund with a 50 percent turnover sells half its holdings each year.
Turnover is important for two reasons. First, frequent trading drives up expenses. Moreover, if fund managers are doing their job, the buying and selling generates more profits than losses, exposing investors to capital gains taxes.
"The more trading there is the more tax issues there are to deal with," said Joseph Grieco, vice president of Sky Wealth Management.
Although capital gains are unavoidable, managers of tax-managed or tax-efficient funds offset them by culling losers from their portfolios as they harvest the winners. That generates losses that can be used to offset gains.
Limiting short-term gains, which are taxed at higher rates than investments held longer than one year, is a prime focus of managers of tax-efficient funds.
Over the past few years, fund managers have used losses rung up during bear market that began in 2000 to offset gains.
However, Mr. Roseen said those accumulated losses are just about gone, which means increased distributions to investors in the years ahead.
Taxes aren't as big a concern for investors in lower brackets, but any investor, regardless of tax status, should be aware of how much taxes reduce returns.
The Block News Alliance consists of The Blade and the Pittsburgh Post-Gazette. Len Boseovic is a business writer for the Post-Gazette.