Albert Einstein once called the income tax "the hardest thing in the world to understand." At least American investors are in the company of genius.

More than ever before, investors are concerned about the tax implications of investments, yet most remain confused by current tax law and either have unrealistic expectations, or are missing out on opportunities to limit tax liability, a recent survey by Eaton Vance of Boston shows.

That creates an opportunity for financial planners and mutual funds to introduce their clients to tax-managed funds. "Until investors realize the impact that taxes have on their returns, it won't catch on," said Tom Roseen, a senior analyst with Lipper of New York. "Broker/dealers don't care because it's not sexy," Roseen said. But tax-savvy investing can add up to 2% per year to clients' returns, he said.

And American investors do care about taxes. Nearly nine out of 10 surveyed (89%) considered the impact of taxes on their investments important, marking the highest proportion of investors in the survey's seven-year history. More than half (52%) said they considered tax implications "very important," representing a 10% increase over the 2004 survey.

Much of the increased awareness can be attributed to the widely publicized and discussed 2003 Tax Act, which lowered the cap on traditional income tax to a maximum of 35% and on capital gains to 15%.

Forty-three percent of respondents believe that taxpayer savings helped boost the country's economic engine, according to the Eaton Vance survey, which was conducted by Penn, Schoen & Berland Associates of Washington. The law is considered so monumental to the American investor that 55% of the 408 investors included in the survey said that they believe that if the law is not extended past its scheduled 2008 expiration, the economy will suffer.

Besides dropping overall tax rates, the law was significant to mutual fund investors because, for the first time, it required funds to disclose information about each fund's tax liability, just as they do for expense ratios. "Until 2003, we as mutual fund investors did not have a way to determine the tax impact of mutual funds," Roseen said. What investors learned is that while an expense ratio greater than 1.5% can seem high, taxes are commonly twice that, he said.

Tax-managed funds offer a way to mitigate investors' tax burdens, and an opportunity for fund companies and advisers to capitalize on that.

As a class, tax-managed funds have been around for roughly a decade. In 1995, Lipper counted 18 such different funds, representing about $3 billion in assets under management. By 1998, there were 64 different products, representing about $18.2 billion. With the stock-market boom between 1998 and 2000, these funds offered an attractive option for investors looking to curb their liability, and by 2000 there were 133 different funds with $29.8 billion.

However, as the recession of 2000 set in, interest waned, and while the number of funds increased to 155, the amount of assets under management dropped to $28.9 billion by 2001, and then slumped to $23.5 billion as the bear market trudged on into 2002.

But between 2002 and the end of 2004, net inflows to tax-managed mutual funds increased more than 71%, increasing assets to $40.2 billion, according to a 2005 Lipper report titled "Taxes in the Mutual Fund Industry." Between 2002, the year before the new tax law took effect, and the end of 2004, 30 new tax-managed fund products were launched, representing a two-year increase of 17%.

While the $40 billion in tax-managed accounts is a big jump over a few years ago, it is still tiny compared to the $2.94 trillion invested in traditional accounts, showing that what investors say and how they act are not always in synch.

"More people may worry about the tax impact, but I don't think they really worry enough to plan," said Louis Barajas, a certified financial planner and tax expert in Santa Fe Springs, Calif. "People are more concerned about gas going up so much, or energy bills - just day-to-day stuff," he said.

Barajas offers tax-managed options to his clients, who range from lower middle class investors with annual household incomes of $30,000, to more affluent investors with a quarter-of-a-million dollars to invest, but he seldom has a client who proactively seeks such products.

Investors often rely on their advisers to help them find tax efficiencies. Among Eaton Vance respondents, 65% had more than $100,000 to invest. And while 50% of those surveyed were aware of some tax-efficient investment vehicles, only 44% had used tax-efficient investment strategies. Of those, 43% learned about these strategies from professional advisers.

"I don't think the average person thinks about the tax situation until they have to cut a check on April 15," Barajas said.

And that means the average investor is probably missing out on savings of between $500 or $600 per year, Barajas figures. "It's not enough that it's life altering," he admitted. But it can become significant if that savings is reinvested and becomes part of a long-term investment plan, he added. Too often, though, investors consider such savings a one-time gain and end up spending the difference, whether on iPods or car repairs.

Barajas' clients are not unique. The Eaton Vance survey showed that while investors are aware and concerned about changes to tax law, they don't really understand them.

One in eight investors surveyed, or about 12%, knew the maximum tax bracket for regular income, and only about one in four, or 27%, knew the maximum rate for capital gains. When it comes to when to choose tax-managed funds, 54% said it would be wise to invest in tax-managed funds through a qualified plan, such as an IRA or 401(k). Another 40% were unsure. In fact, the opposite is true.

The 2003 law also left many with a skewed sense of capital gains. While 47% of those surveyed paid capital gains taxes in 2004, and 65% had paid such taxes within the past five years, only 46% of investors surveyed expect to pay capital gains in 2005.

"Unfortunately, investor's views on capital gains are an example of hope triumphing over experience," said Duncan W. Richardson, chief equity investment officer at Eaton Vance. "Even with modest returns this year, capital gains distributions could be quite high," he said.

"When they open their 1099-DIV forms this year, they're going to get a little sticker shock," Roseen said. Although 2003 delivered the best returns for mutual fund investors since 1968, many people's tax bills were offset by carry-over losses from the preceding bear market. But those credits, most likely, are all gone now, and many people will face bills bigger than those they've seen since 2000 or before. "The monster is back out," he said.

That may renew investors' interest in tax-managed funds, and with it a better understanding of how the revised tax codes can mean more savings than ever. "People have not gotten the word, and they really don't know the impact," Roseen said. But it doesn't take a genius to see that tax-savvy savings add up fast.

(c) 2006 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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