Personal Finance: The mutual fund tax trap
Thinking about putting new money into a mutual fund soon? Stop! You may want to wait until the start of the new year.
Here's why: Every year, mutual fund managers realize capital gains in their portfolios as they sell stocks at a profit. As they book these gains, however, they are required to distribute those profits to shareholders in what's known as a capital gains payout.
Money back is a good thing, right? Actually, not always. That's because shareholders are left to pay taxes on these distributions, which typically are issued in late November or December. In other words, if you put $1,000 into a stock fund today, in a few weeks that fund may return to you $100. You can choose to reinvest that money in the very same fund, or you can just spend it. But either way, you're on the hook for taxes on that C-note, provided you own that fund outside a 401(k) or IRA.
In recent years, no one has talked about capital gains distributions because they haven't been an issue. Remember, during the bear market years, stock fund losses swamped gains, which meant many funds didn't have to make capital gains distributions at all.
Even in 2003 and 2004, when stock funds did quite well, many funds were able to carry forward losses on their books from the bear market years. They used those losses to offset gains, reducing the need to make a big year-end payout.
But a number of funds have used up their capital-loss carry forwards. At the same time, stock funds have been on a tear since the market bottomed in October 2002. The combination of these two trends means stock funds are likely to make their biggest taxable distributions since the bear market of 2000. "We need to start worrying about year-end distributions again," warns Tom Roseen, senior research analyst for the fund tracker Lipper.
Does this mean you shouldn't put any new money to work in a fund until the end of December? No. Not all funds are going to make distributions this year. But here are a few things you can do:
Check to see if a fund you're interested in is going to make a payout this year. Many mutual fund companies are already giving guidance about which funds are expected to make distributions. This information should be available on their websites. If you're planning to invest in a fund that's on the verge of issuing a big taxable payout, wait until it kicks out that money before you step in.
Think about investing in funds that don't traditionally make big year-end payouts. These include funds that rarely sell stocks, like index funds or conservative, buy-and-hold-oriented portfolios. After all, if a fund doesn't sell stocks frequently, it won't book capital gains frequently. Another type of fund to consider is a so-called tax-managed portfolio. These funds manage stocks with an eye toward reducing taxable distributions.
Consider investing in a fund that hasn't done so well this year. This is a classic "value" approach to investing—remember, the point is to buy low so you can sell high. According to Morningstar, the types of funds that are still likely to be sitting on losses from the bear market are large-cap stock funds, growth-oriented stock funds, technology funds, and telecommunications sector funds. Portfolios that are probably sitting on big gains include energy sector funds, real-estate funds, emerging markets stock funds, small-cap stock funds, and value-oriented portfolios.
Currently, Congress is considering a bill called the Growth act, which would allow investors to defer taxes on capital gains distributions if those investors automatically reinvest the gains in additional shares of the fund (which many investors do). While this proposal may eventually become law, it may take years. And until—and unless—that happens, investors are on their own.
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