Fund investors may pay record taxes on capital gains

U.S. mutual-fund investors may pay record capital-gains and dividend taxes for 2007 even though many of their holdings fell in value, according to analysts at Lipper.

Taxes on fund distributions probably will surpass the record $31.3 billion paid for 2000, said Tom Roseen, a senior analyst at the Denver-based investment-research company.

Capital gains are distributed to shareholders when funds sell assets that have increased in value since purchase. As financial markets declined in the second half of 2007, fund managers sold securities to lock in returns and in some cases meet redemptions. Funds also pass along dividends and interest paid by the stocks and bonds they own.

“By far, it’s shaping up to be the worst year for long-term and short-term capital gains on record,” Roseen said in an interview.

The average U.S. stock fund rose 6.4 percent last year, while taxable bond funds returned 4.6 percent, according to data compiled by Morningstar Inc., a Chicago-based funds-research firm.

Distributions made in 2007 by all non-money-market funds may have increased to more than $500 billion from $419 billion a year earlier, Roseen said. Capital gains are taxed at rates as high as 28 percent, while investors pay as much as 15 percent on dividends.

The surge in capital gains stemmed in part from defaults on subprime mortgages that triggered losses on asset-backed bonds. Write-downs and credit losses for financial institutions since mid-2007 have topped $245 billion. The Standard & Poor’s 500 Index has fallen 15 percent from its 2007 peak on Oct. 9.

Many investors have soured on all but the safest investments, such as U.S. Treasuries. Last year, many began shifting out of stocks and bonds and into money-market funds, which now hold a record $3.49 trillion, according to the Money Fund Report, a Westborough, Massachusetts-based newsletter. In October and November, $11 billion moved out of U.S. stock funds.

Lipper’s Roseen said he expects the big tax bills will make investors pay more attention to after-tax returns. More people may buy indexed funds and exchange-traded funds, which can be more tax-efficient than actively managed funds because they make fewer transactions, reducing capital-gains distributions. An ETF can also sell shares without incurring capital gains through arbitrage strategies that keep the fund price tied closely to the net asset value.

A high tax bill may also make investors give more consideration to tax-managed funds, which place more emphasis than traditionally managed funds on the tax implications of trading, Roseen said.

“So much is written about the high cost of mutual-fund fees,” which average 0.76 percent a year when weighted by investors’ assets, Roseen said. “The tax bill is twice that.”