Buy at Year-End Without Capital Gains’ Bite

There’s a painful surprise in the making for stock fund investors this year. Even though most such funds will probably finish 1990 with a loss, many will report a capital gain for the year. As a shareholder, you will owe taxes on this amount, unless you’re investing through an individual retirement account or similar tax-sheltered plan.

This unpleasant paradox results from the fact that mutual funds pass their capital gains and losses through to shareholders, who foot the bill as if they directly owned the securities that the portfolio manager sold.

In bullish years, such as 1989, investors can expect to pay taxes on a fund’s gains. But many people will undoubtedly be caught off guard in 1990, considering how poorly the stock market has fared. “It’s possible that many investors could have double-digit losses on equity funds while receiving capital gains distributions,” says Steve Norwitz, a vice president at T. Rowe Price Associates, the Baltimore-based fund company.

Bond funds also might post capital gains, but the amounts usually are smaller and declared over the course of a year, not all at once. Stock portfolios, by contrast, commonly report just one big annual distribution, usually in December. That makes the last month of the year a treacherous time to invest new money, since you will want to avoid this payout if possible.

A survey by the L/G No-Load Fund Analyst newsletter of San Francisco provides a glimpse as to what might be in store. The newsletter recently polled 37 mutual funds as to whether they expected to make a capital gains payout this year. Thirty responded affirmatively. “It appears that the majority of funds will have some distributions, amounting to about 3% to 5% of net asset value,” says Ken Gregory, co-editor of the newsletter. In some cases, the payout will exceed 10%.

How can a fund lose ground and yet report taxable gains? It results when a portfolio manager realizes profits on stocks bought at lower prices in previous years, explains Gregory. Also, a year-end payout might include some interest or dividends earned on the securities held.

Of course, the size of a capital gains payout will have been reduced by the amount of any losses. So for a fund to make a distribution, its winning positions must exceed its losers. But that’s not unreasonable, even in a down year such as 1990, when you consider that some funds still hold many stocks acquired at lower prices during the 1980s.

What makes the capital gains dilemma more perplexing is that you might owe taxes for 1990 even though you don’t receive the money until early next year. As long as the distribution is declared by Dec. 31, 1990, and paid by Jan. 31, 1991, you need to include it when preparing your current year’s tax return.

In fact, you don’t have to take the distribution in cash to get tagged with a tax bill. Even if you reinvest your capital gains or dividends in new shares, you will likely owe something to Uncle Sam and California authorities, too.

Does it pay to sell your fund before the distribution date to avoid paying the capital gains levy? Probably not. “I never recommend selling only for tax purposes. It always depends on the underlying economics of the investment,” says Ken Anderson, a tax partner in the Los Angeles office of the big accounting firm Arthur Andersen & Co.

However, it’s wise to delay buying more shares or making a new investment until after the fund declares a capital gains payout. “If you buy just before the distribution, you immediately incur a tax liability. You have acquired a share of the other (shareholders’) profits,” explains Sheldon Jacobs, editor of the No-Load Fund Investor newsletter in Hastings-on-Hudson, N.Y.

Call the fund to find out the declaration date, known as the “ex-dividend date.” (The actual payment date may be a week or more later). “It’s wise to do a little homework before making an investment this time of year,” Gregory says. “You don’t want to buy into a fund before it makes a big distribution.”

Conversely, assuming the fund has more capital losses than gains, can you expect an immediate tax deduction? Unfortunately, no. Fund companies aren’t allowed to pass net losses directly to shareholders. However, they can use those losses in future years to offset any profits that might be made.

This means a fund won’t distribute capital gains until it has offset remaining losses from previous years. “Because the Internal Revenue Service permits funds to carry these losses forward for five years, shareholders can enjoy a considerable grace period while the fund is accruing new gains,” Jacobs points out. He suggests checking the prospectus or quarterly reports for information on accrued gains or losses. With the market down in 1990, more funds will likely have loss carry-forwards next year.

Keep in mind that the preceding discussion relates only to actual, realized gains and losses--transactions in which the portfolio manager has already sold stock.

It’s a different story with unrealized or paper gains and losses. These open positions don’t have immediate tax consequences, but they will down the road. So if you invest in a fund with sizable unrealized gains, you will likely face a tax liability when the portfolio manager decides to sell the issues.

Conversely, on a fund showing large paper losses, the manager might be able to shelter future profits. “At the moment, not that many funds have realized losses, but many have unrealized ones,” Gregory says. Again, scan the prospectus or quarterly reports for details, or call the fund company.

In addition to these tax angles, which deal with the gains or losses that the portfolio manager incurs by trading stocks, you will face your own capital gains or losses, depending on the prices at which you bought or sold shares in the fund itself.

Fortunately, you can reduce the tax liability (or increase the writeoff) on your own investment by including the impact of the fund’s gain or loss transactions. For example, if you’ve already paid a tax on a profit generated by the fund manager, you can reduce your own capital gains liability by the same amount when you sell shares. For this reason, it pays to retain account statements and other pertinent records.

Certainly, your decisions to buy or sell mutual funds should be based on investment potential, not taxes. But if you can dodge a large year-end capital gains bite when purchasing shares in December, you’ll be off to a better start.

DODGING THE DECEMBER TAX BULLET

It pays to avoid capital gains distributions declared by stock mutual funds, typically during the last month or so of the year. A distribution will give you a tax liability without boosting the value of your account.

To illustrate, suppose you can choose to invest $1,000 into a fund at $12 a share on Dec. 14, one day before the fund declares a $1-a-share distribution, or on Dec. 16. And further imagine that the price doesn’t change over that span, other than dropping from $12 to $11 to reflect the distribution. Here’s how you would fare under the two scenarios:

Scenario 1 (Buy on Dec. 14) Number of shares purchased ($12 each): 83.33 Value of shares after distribution ($11 each): $916.67 Value of distribution ($1 a share ): $83.33 Value of investment (Dec. 16): $1,000.00 Capital gains liability for 1990: $83.33

Scenario 2 (Buy on Dec. 16) Number of shares purchased ($11 each): 90.91 Value of investment (Dec. 16): $1,000.00 Capital gains liability for 1990: $0.00

Under the first scenario, you could reinvest the $83.33 distribution in 7.58 new shares, raising your total to 90.91. The account value would stay at $1,000, but you would still have the $83.33 tax liability.