IndexFunds.com Staff

SEC Mandates Disclosure of Mutual Fund After-Tax Returns

The Securities and Exchange Commission (SEC) adopted a rule on Friday that requires fund companies to disclose after-tax returns for 1-, 5-, and 10-year periods in fund prospectuses. The SEC first proposed the new rule in June 2000.

The new rule underscores the growing, albeit slowly, awareness of mutual fund taxes and how they can affect returns - the SEC cited recent estimates that more than 2.5% of the average stock fund's returns were eaten up by taxes. According to the SEC, mutual funds distributed approximately $238 billion in capital gains and $159 billion in taxable dividends in 1999.

Although many financial periodicals and websites cover how taxes affect returns, the SEC recognized a general lack of understanding among mutual fund investors. In a recent survey, 85% of fund investors acknowledged the significant impact of taxes on fund returns. However, only 33% felt they were very knowledgeable about the tax implications of investing, and only 18% were able to identify the maximum rate for long-term capital gains.

"Taxes can be the most significant cost of investing in a mutual fund," said Paul Roye, Director of the Division of Investment Management at the SEC, on Friday. "Today's action addresses the gap between the importance of taxes to mutual fund investors and the knowledge that investors have about taxes."

According to the new rule, after-tax returns must be presented in two ways - after taxes on mutual fund distributions, and after taxes on mutual fund distributions and sale of mutual fund shares:

• Return after taxes on distributions reflects the tax effects on fund shareholders that come as a result of securities purchases and sales by the fund's manager.
• Return after taxes on distributions and sale of fund shares reflects the tax effects of security purchases/sales, as well as the tax effect of a shareholder's decision to sell fund shares.

In order to ensure consistency across the industry, the SEC said before- and after-tax returns must be presented in a standardized table accompanied by an explanation of the methodology for calculating the returns.

The SEC also mandated that after-tax returns be calculated at the maximum individual federal income tax rate. The SEC's rationale for this system is that it provides investors with the "worst-case" tax scenario, and allows investors to anticipate the full range of after-tax returns by comparing before-tax and "worst-case" after-tax returns.

Mutual fund advertisements that include any after-tax returns or any claims that the fund is managed to limit taxes must include the standardized after-tax returns.

Finally, the SEC said money market funds and tax-deferred funds such as 401(k) plans or variable annuities are exempt from the new rule.

The full text of the new rules is available at the SEC website.