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Beware the tax trap with mutual funds

The end of the year can be a great time to rebalance your portfolio and unload poor performers, but wise investors know to do a bit of research before buying and selling mutual funds in December.
/ Source: The Associated Press

The end of the year can be a great time to rebalance your portfolio and unload poor performers, but wise investors know to do a bit of research before buying and selling mutual funds in December.

All year long, equity mutual funds add and subtract from their stock holdings, and when they sell shares at a profit, they generate capital gains, which are taxable. At the end of the year, funds that wind up with net capital gains share the bounty — and the tax burden — with investors by making distributions.

This year, with many stocks advancing and fewer losses being carried forward from the bear market, a greater number of funds are expected to report capital gains. The dates of these distributions vary, but most take place in December.

Not all funds make capital gains distributions, and they are not an issue for tax-deferred portfolios, such as an individual retirement account or a 401(k). But for the portion of your portfolio that is taxable, capital gains distributions are worth paying attention to at this time of year, said “Mutual Funds for Dummies” author Eric Tyson.

“Suppose you buy into a fund that’s currently trading at $20 per share, and you don’t realize that $1 of the share value is an undistributed capital gain,” Tyson said. “When the fund pays that $1 in capital gains in December, essentially you’ve had 5 percent of your initial investment returned to you as a taxable capital gains distribution.”

It’s a mistake even the most seasoned investor can make if they forget to check. In general, if it’s a matter of days, it’s probably best to wait until after gains have been distributed before buying into a new fund. Likewise, if you own a fund that is reporting gains and you’re planning to unload it anyway, you’re better off selling it before the distribution date. Fund companies often list expected capital gains and distribution dates on their Web sites, or you can get details by phone.

“I think this is a good time of year to review your investments,” Tyson said. “For people who are in mutual funds, it’s a good time to review their funds’ performance versus their peer groups. Many investors follow their funds too closely, but then others tend to be too hands off. Once a year, it’s a good reminder to check on your funds and make sure they’re doing what you were hoping and expecting they would do.”

While tax implications are important, they shouldn’t dictate your investing decisions, Tyson said. And you should never let something like a capital gains distribution keep you on the sidelines for a prolonged period of time. Chances are any tax savings would be far outweighed by lost market returns, especially during the seasonally strong months of November and December.

“We’ve done the math, and it shows that unless you’re actually thinking about buying a fund within a few days of the distribution, you should not hold off,” said Francis Kinniry, principal of Vanguard’s investment counseling and research group. “Whatever taxes are due will be small compared to what the market could potentially return. If someone has money to invest in October and November and the first week of December, they should be aware of the distribution and not be blindsided by it, but they should put it in context.”

At the same time, Kinniry noted, if you find you’re paying significant taxes on capital gains distributions year after year, you might want to reconsider your strategy. While investors are often well aware of the costs associated with expense ratios, they may not realize how much of their total return is lost to capital gains taxes; it can be upward of 3 percent in the actively managed fund universe.

For this reason, in the taxable portion of your portfolio, you might prefer funds that limit capital gains. Some, such as index funds or exchange traded funds, generate very few taxable gains because of the way they are structured. There are also tax-managed mutual funds where portfolio managers use techniques to offset capital gains.

“That doesn’t mean active managers don’t have a place in your portfolio, but they should probably be in your IRA or other tax-deferred account,” Kinniry said. “For long-term taxable investors, the broad index funds and the tax-managed mutual funds are extremely difficult to beat.”

A law passed last year provides some relief for investors, in that it limits taxes on qualified stock dividend payments to a maximum of 15 percent. Dividends used to be taxed as regular income. In addition, the tax rate on long-term capital gains — profits made on the sale of stocks held for more than a year — dropped to 15 percent from 20 percent. But short-term capital gains, interest payments on bonds and most real estate investment trusts are still taxed at the highest marginal rate.

Of course, taxes are just one of many factors you should weigh when shopping for funds. Consistency of strategy, duration and expertise of management and overall expenses are also important considerations, said Gareth Lyons, an analyst with fund research firm Morningstar Inc.

“If you’re prudent about it, you can avoid some of the tax traps,” Lyons said. “This is an important issue. But I think it’s secondary compared to assessing some of the other aspects.”