By contributor
updated 10/24/2007 7:36:17 PM ET 2007-10-24T23:36:17

Most experts recommend steady-stream investing — adding the same amount every month or quarter.

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But not always. At this time of year, mutual fund investors should keep an eye out for unwelcome capital gains distributions. While it’s too soon to know for sure, the stock market’s healthy gains for the past couple of years could yield unusually heavy distributions in November and December — producing big tax bills next April.

You can avoid that tax by postponing fund investments until after the distributions are made.

By year end, funds must tally profits and losses made on stocks or other holdings fund managers sold during the year. If the result is a net profit, it must be paid to the fund’s shareholders.

Unless the fund is held in a tax-deferred account such as a 401(k) or IRA, the distribution is taxable — even if you reinvest it in more fund shares.

The payouts are reported on the Form 1099 sent out by the fund company in January. Short-term capital gains, for investments the fund had owned less than 12 months, are taxed at income-tax rates as high as 35 percent. Long-term gains, for holdings held longer than 12 months, are taxed at the long-term capital gains rate of no more than 15 percent.

Distributions grow when the markets do well. The record was $326 billion paid out in 2000 after the spectacular stock-market run of the late 1990s, according to the Investment Company Institute, the fund-industry trade group. The stock collapse that followed knocked distributions so far down that they were of little concern for several years. The total fell to $69 billion in 2001, $16 billion in 2002 and $14 billion in 2003.

Although the market then started to recover, funds used losses carried over from previous years to keep distributions to $55 billion in 2004. But the figures jumped to $129 billion in 2005 and $259 billion in 2006.

As previously mentioned, distributions are not a problem for funds in tax-deferred accounts, which hold more than half of Americans’ fund investments. Still, distributions to taxable accounts held by ordinary households hit $89 billion last year, compared to $6 billion in 2002. The record was $117 billion in 2000.

(Bond funds make distributions too, but they’re generally small — just $2 billion last year, compared to $238 billion from stock funds.)

At first glance, distributions look like a good thing — a payment that boosts returns. But it doesn’t work that way because the fund’s share price falls when the money paid to shareholders reduces the fund’s assets.

Imagine a fund with a share price, or net asset value, of $10. Suppose it distributed $1 per share. If you owned 1,000 shares, you’d receive $1,000. But the share price would drop to $9. So your holdings after the distribution would be $9,000 in shares and $1,000 in cash – the same as the $10,000 in shares you’d had before the distribution.

Assuming you paid a long-term capital gains tax of 15 percent, you’d owe Uncle Sam $150 for the distribution.

And it can get much worse. Some funds occasionally make distributions equal to 20 or 30 percent of net asset value. The American Century Ultra Fund, for example, expects a distribution equal to 21 percent of net asset value this year.

Paying tax on investment gains is a fact of life. Had you owned the shares for years, you’d have enjoyed gains reflected in a rising share price, and a tax on distributions wouldn’t seem so bad. But if you bought the shares the day before the distribution, you would not have been around for the gain — but you’d pay a tax on the distribution anyway.

If you instead invested after the distribution, you would still enjoy any future gains, but you’d avoid the tax bill on the previous ones.

To do this, call the fund company or look on its Web site, where many firms post distribution estimates starting in October. Find out how large any distribution will be and look for the “record date.” People who own the shares as of 4 p.m. Eastern time on that date will get the distribution. Anyone who buys afterward will not.

If the company does not yet have a distribution estimate, look for a figure called “realized gains.” These are the net profits earned thus far this year. They will be paid out as distributions, though the final figure could change before the books are closed.

Of course, the tax tail should not be allowed to wag the investment dog. If you thought the fund was going to soar between now and the record date, you might want to invest now anyway. Most small investors, however, should not engage in this kind of short-term market timing.

If you’ve found an appealing fund that is likely to pay a large distribution, you can also avoid tax by investing through a tax-deferred account such as an IRA or 401(k).

But in your taxable accounts it makes sense to buy funds that aren’t likely to make big distributions this year or in the future. Distributions tend to be biggest in "managed" funds that constantly buy and sell in search of hot stocks. All that selling causes paper gains to be taken, or "realized."

Look for a “turnover” figure, which shows the percentage of the fund’s holdings that change each year. High turnover can mean big distributions. You can find this figure on Morningstar's fund-search Web site.  While there, click the “tax analysis” button. That will show how tax bills produced by distributions have reduced returns in the past.

Index funds, which buy and hold stocks in market indexes such as the Standard & Poor’s 500, tend to have very small distributions — and therefore small annual tax bills. That’s because they rarely sell holdings. Exchange-traded funds, which are index funds that trade like stocks, are also kind to shareholders at tax time.

In addition, there are a number of “tax-managed” funds that use various strategies to minimize taxes. They try to limit turnover and to hold winners long enough to get the lower long-term capital gains tax rate. And they look for opportunities to sell money-losing investments in time to offset gains on winners. You can search for these funds on the Morningstar site.

Finally, stand back and look at the big picture. Do you have investments that can be sold for a loss? When you prepare your tax return, any losses will be subtracted from gains realized through distributions or sales of profit-making investments.

Remember, though, that some funds make big distributions year after year, and you might not have offsetting losses in the future.

So be kind to yourself: Avoid packing your taxable accounts with funds that have a habit of making big year-end distributions.

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