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Investors Savvier About Taxes, But Still Need Advice


Investors are placing greater importance on the tax implications of investing and support an extension of tax cuts. However, many are confused when it comes to tax efficiency and have unrealistic expectations about potential gains distributions and, therefore, need advice, according to the findings of the seventh annual "National Investor Survey" by Eaton Vance of Boston. Penn, Schoen & Berland Associates of Washington conducted the survey, polling 408 investors in both qualified and non-qualified plans in the final two weeks of November.

Nine out of 10 investors (89%) said that the impact of taxes on their investment returns is important to them, the highest percentage to say so since the survey began. Of these, 52% described the impact of taxes as very important, up from 42% the year before.

"Although we likely won't know until next spring what will become of the 2003 Tax Act, a majority of investors seem to support an extension of the tax cuts for economic reasons," said Duncan W. Richardson, chief equity investment officer at Eaton Vance. "If investors are hit with substantial capital gains this year, their enthusiasm for continued capital gains tax relief could well build into a march on Washington come tax time."

Half of the survey takers admitted that they are concerned they may be subject to increasing capital gains taxes. Nearly half (47%) said they paid capital gains in 2004, and 65% said they paid within the past five years. However, only 46% of investors claimed they are expecting to pay capital gains this year.

"Unfortunately, investors' views on capital gains are an example of hope triumphing over experience. There is little to justify investors' apparent expectation that capital gains taxes will be flat year-over-year," Richardson said. "In fact, even with modest equity market returns this year, capital gains distributions could be quite high."

According to data provided by the Chicago-based fund tracker Morningstar, in 2002, the average domestic equity mutual fund had unrealized capital losses equal to 47% of its assets. Since this time, equity returns have cancelled out capital losses, resulting in an increase in capital gains distributions. From 2003 to 2004, short-term capital gains paid by mutual fund shareholders doubled from $5.2 billion to $11.8 billion, and long-term capital gains quintupled from $9.96 billion to $50.22 billion, according to Lipper of New York.

Currently, investors know more about tax efficient investing than in past years. In fact, 18% selected low-yielding growth stocks held long term and 32% selected municipal or tax-free bonds among the types of investments they believed to offer the greatest efficiency. The survey also revealed that 44% invest with specific tax consideration, up from 27% in 2001.

Forty-three percent of investors said they selected tax-managed funds due to the advice of financial advisers. Last year, 29% of respondents said that their advisers had recommended tax-managed funds. Of the 36% who said they are familiar with tax-managed funds, 40% have invested in them, up from 29% in 2001.

Investors also expressed an interest in learning more about how taxes affect their investments. Roughly 70% of investors carefully review statements from their investment managers with regard to tax implications, and 84% said that disclosures by fund companies on the tax implications of investing are important.

While investors' awareness and interest in taxes has increased, their actual detailed knowledge still remains low, as only one in every eight investors (12%) can correctly cite the current maximum Federal tax rate for ordinary income, and only one out of every four (27%) can identify the Federal tax rate for long-term capital gains.

"Many investors don't appear to realize that the 2003 Tax Act created some great opportunities to increase after-tax returns," Richardson said. "Studies have shown that 2% per year is unnecessarily lost to taxes. It is a near certainty that tax-savvy financial advisers can add value year in and year out by recovering some of that 2% for their clients through simply knowing and making use of the current tax code."

The study found that investors need help in identifying the most suitable investments for qualified retirement plans like an IRA or a 401(k). Of those polled, 40% believe that tax-managed stock funds are best held inside a qualified plan, and 14% are not sure, while 46% understand that these types of funds are best held outside of a plan. As for municipal bond funds, 52% of investors said that they were better held outside of a qualified plan.

And when it comes to variable annuities, investors are even more confused, as 38% of respondents said they would be inclined to hold variable annuities within a qualified plan, 37% said outside of a qualified plan, and 25% said they did not know.

"Of course, each of these tax-advantaged investments is best utilized outside a qualified retirement plan," Richardson said. "Investors should generally use their qualified retirement plans to shield investments that would otherwise be fully taxable. Investors who are unsure of how best to use qualified plans should consult a financial adviser to help them make the correct investment decisions."

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