Academic journal article Journal of the International Academy for Case Studies

Mutual Funds' Before- and After-Tax Returns: The Case of Tax clientele.(Instructor's Note)

Academic journal article Journal of the International Academy for Case Studies

Mutual Funds' Before- and After-Tax Returns: The Case of Tax clientele.(Instructor's Note)

Article excerpt

CASE DESCRIPTION

The primary subject matter of this case concerns the taxation of mutual funds. Secondary issues examined include the concept of tax clientele, basic differences in the taxation of capital gains and ordinary income, basic differences in the tax consequences of holding mutual funds versus individual stock portfolios, and the characteristics of tax-efficient mutual funds. The case has a difficulty level of four, most appropriate for senior level students. It could also be used at the advanced junior level or beginning graduate level. The case is designed to be taught in one class period (approximately 75 minutes) and is expected to require 3-5 hours of outside preparation by students depending upon whether the advanced requirements are assigned.

CASE SYNOPSIS

This case introduces students to the tax issues related to a major player in the investment and retirement savings market--mutual funds. It also emphasizes the importance of considering after-tax rates of return in the investment decision. The case examines the interplay between tax rules and mutual fund rates of return by comparing pre- and post-tax rates of return for eleven common mutual funds over a two-year period, 1999-2000, which includes both bull and bear markets. The concept of tax clientele is introduced, for without a specific clientele, meaningful after-tax rates of return cannot be computed. Furthermore, basic differences in the taxation of capital gains and ordinary income as well as basic differences in the tax consequences of holding funds versus individual stock portfolios are examined. After completing this case students should be able to (1) calculate pre- and post-tax mutual fund returns; (2) rank funds based on a tax client's tax rates and after-tax returns; (3) understand the long-term effect of taxes on mutual funds returns; (4) develop strategies to maximize the investor's after-tax return; and (5) identify characteristics of tax-efficient funds.

The case is appropriate for assignment in undergraduate accounting and finance classes as well as for an exercise in graduate classes studying tax strategy. Several possible teaching approaches can be used to present this case and to extend the basic requirements. In its simplest form, by covering just the basic requirements, the case is an introduction to mutual fund taxation and mutual funds in general. It also serves as an exercise to enhance spreadsheet skills. In a more advanced setting, the basic requirements in the case can be used to motivate class discussion of the conceptual issues related to tax clientele and the importance of comparing after-tax returns in investment choice.

INSTRUCTORS' NOTES

The purpose of the case is twofold. First, it introduces students to the tax issues related to a major player in the investment and retirement savings market, mutual funds. Second, it emphasizes the importance of considering after-tax rates of return in the investment decision. The SEC has recognized the importance of this second objective and has recently required that mutual fund prospectuses report the impact of taxes and sale charges on fund returns. Prior to these new rules, most funds reported their performance results without taking taxes into account. Unfortunately, these new disclosures will generally appear only in the fund prospectus. The new disclosures are not required to appear in advertising unless the fund is presented as a tax-efficient fund. Additionally, the new disclosures can be confusing since the new rules require that the fund prospectus include not one, but two standardized measures of after-tax performance. The new measures also assume that gains are taxed at maximum federal rates. (Wall Street Journal, April 12, 2002, C1).

Even with this disclosure requirement, accounting students (or financial advisers) need to know how to calculate a fund's after-tax rate of return for the following reasons: (1) many investors are unlikely to carefully read a fund prospectus, (2) not all taxpayers are at the top marginal tax rates which the new disclosures assume, and (3) not all investors have the same goals or objectives. …

Search by... Author
Show... All Results Primary Sources Peer-reviewed

Oops!

An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.