Ward off mutual fund tax pain
- By Milt x_Zall
- Nov 16, 2000
Sometimes it's downright painful to make money.
Millions of shareholders will receive statements October through December
announcing year-end capital gains distributions made by their mutual funds.
In some cases, those distributions will be hefty — as high as 55 percent
of a fund's total assets — or from funds that actually declined in value
for the year.
In either case, many shareholders with taxable accounts don't want the
distributions because they don't want to pay taxes on them yet.
While there's nothing you can do to stop the distributions, you can
take some short-term actions that might offset or avoid some of the tax
pain. Long-term, you can take actions that will reduce the distributions
dilemma in the first place, says Dennis Filangeri, a certified financial
planner based in San Diego.
First, you need to understand the problem. During the course of the
year, most mutual funds sell some of their profitable stocks, bonds or other
assets. They may sell for a variety of reasons: profit-taking from winners;
a new fund manager or a new fund strategy "cleans house"; or shareholder
By law, nearly all of the capital gains generated from these sales must
be distributed to shareholders by the end of the year. An individual shareholder
can cash them out or have the fund reinvest the distributions. Either way,
shareholders must record the gains on Form 1099-DIV with their income tax
return. For short-term gains (held less than 12 months), you pay ordinary
income taxes. For long-term gains, you pay no more than a 20 percent rate
and possibly as low as 10 percent.
So what can you do to minimize the tax bite? First, you won't have a
tax bite on any gains from funds held in a tax-favored account, such as
a 401(k) plan, variable annuity or an individual retirement account. You
won't pay taxes on those gains until you start withdrawing money from the
accounts, though it will be at ordinary tax rates.
For taxable accounts, there are several things you might do. First,
find out the fund's "ex-dividend" date and the approximate percentage of
the net asset value that will be distributed. If the distribution is going
to be large, and you've earmarked the fund to sell anyway, consider getting
out before the distribution.
You also can offset some or all of your gains by selling other investment
losers you've wanted to get rid of. All this can involve some tricky tax
and investment issues, so it's best to consult your certified financial
planner or tax accountant before proceeding.
Also, avoid buying heavily into a mutual fund just before it declares
a capital gains distribution. Otherwise, you'll end up paying taxes on money
you didn't actually earn. In the long term, you can take several steps to
minimize taxable distributions:
* Consider investing taxable money in index or "tax-efficient funds."
Funds that track an index such as the S&P 500 don't turn over stocks
unless the index does or there is heavy shareholder redemption. Tax-efficient
funds tend not to sell stocks often or try to offset profitable sales with
losses. However, Filangeri cautions that ultimately it is the after-tax
return that counts, not just what taxes you save. A poorly performing "tax-efficient"
fund can easily leave you with less after-tax return than a high-performing
fund that is not too efficient.
* Avoid high-turnover funds that may turn over their entire portfolio
two, three, even four times in a single year, potentially generating a lot
of taxable gains.
* Consider avoiding the purchase of funds that have a high percentage
of unrealized capital gains that will generate taxable gains upon their
* Consider individual stocks. The advantage of owning individual stocks,
bonds and other assets is that you don't incur capital gains taxes until
you sell. You may even be able to avoid them altogether if you pass on the
securities to charity, or to your heirs at death. The caveat here is that
you need to have a sizable portfolio in order to diversify among dozens
of investments. Diversification is one of the great advantages of mutual
funds, and can help offset some of the tax disadvantages.
Zall, Bureaucratus columnist and a retired federal employee, is a freelance
writer based in Silver Spring, Md. He specializes in taxes, investing, business
and government workplace issues. He is a certified internal auditor and
a registered investment adviser. He can be reached at [email protected]