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.
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.
Mutual funds have become an investment vehicle of choice for many investors seeking capital appreciation. With a net asset base of $5 trillion, there are now more mutual funds for investors to choose from than there are securities registered on the major exchanges (Brooker 1998). Understanding how mutual fund investments are taxed prepares the individual for the next critical step, which is to understand the impact that taxes can have on the overall performance of their investment program. Effective tax planning can substantially boost the net returns received from mutual fund investments, particularly for those investors in high tax brackets.
To help investors assess mutual fund performance, the SEC recently required that mutual fund prospectuses report the impact of taxes and sale charges on fund returns. In spite of these new disclosure requirements, accountants and investment advisers should 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 and many investors may not understand the data presented, (2) not all taxpayers are in the top marginal tax rates which the new disclosures assume, and (3) not all investors have the same goals or objectives. …