Bad Timing on Purchase Can Increase Tax Bite

There’s never a bad time to make a good investment or a good time for a bad investment, but there is a time to avoid unnecessary mutual fund taxation, and it’s drawing near.

During the next couple of months, particularly in early December, stock funds will declare their capital gains for the year and pass them on to shareholders. If you’re holding a mutual fund within a tax-sheltered retirement plan, you have nothing to worry about. Otherwise, be careful.

The reason is simple: If you purchase shares shortly before a fund declares a distribution, you will face a liability for the entire year’s taxable gains--effectively picking up part of the tab on profits earned by the portfolio manager for other shareholders.

“It doesn’t make sense to invest on Dec. 1 in a fund that will throw off 15% to 20% in capital gains distributions later that month,” says Ken Gregory, co-editor of the L/G No-Load Fund Analyst newsletter in San Francisco. And this year, with the market up sharply, many stock funds will declare some hefty gains.

That’s why it’s a good idea to call the fund company and inquire about the expected size and timing of a distribution before you purchase. The relevant date is the declaration or “ex-dividend” date, which might precede the actual payment date by a week or more. Some firms notify shareholders by mail in or around October concerning their year-end plans. “Find out when the fund is going ex-dividend and buy at least a day after that,” advises Roy Weitz, a senior manager specializing in personal tax matters for Price Waterhouse in West Los Angeles.

Assuming you plan to hang on to your investment for many years, it’s not a big deal if you get stuck paying a larger current tax than necessary. After all, you do get a payment reflecting the capital gain, either in cash or shares that you can reinvest. Besides, what you pay next spring to Uncle Sam will reduce your tax bill in future years. “In the long run, it all pretty much evens out,” Gregory says. But if you tend to jump in and out of funds or simply don’t like the idea of paying for something you didn’t get, take heed.

During years when interest rates drop, such as 1991, bond funds might also post some capital gains. Usually, however, the amounts involved are relatively small. With most bond funds, the main tax liability results from interest dividends.

It’s important to keep in mind that there are two categories of capital gains and losses with mutual funds. First, there are the gains or losses that the portfolio manager accumulates over time by buying and selling securities. These are passed on to shareholders in year-end distributions. Second, every time you purchase or redeem shares, that’s a taxable event based on the prices at which you traded.

You can skirt taxes on the first type of capital gains by selling your fund now and buying back after the distribution date. Just be careful not to run afoul of the Internal Revenue Service’s “wash sale” rule, which bars you from deducting a loss in a fund that you subsequently repurchase. To skirt this prohibition, which also applies to stocks, you must wait 31 days before buying shares in the same fund. The wash sale rule also affects bond funds and can be a problem if you elect to have monthly dividends reinvested automatically.

If you’re planning to buy shares, consider delaying your purchase for a few weeks. Although there’s always a chance the market could move higher late in the year, stock prices have tended to languish over this period (see table).

Some analysts believe that stock prices tend to stumble or at least consolidate in fall simply because they usually follow on the heels of summer rallies. Others blame small investors for depressing the market before year-end with tax-loss-related selling of individual stocks, thereby setting the stage for New Year rallies.

Steven E. Norwitz, a vice president at T. Rowe Price Associates, a Baltimore fund group, speculates that mutual fund managers might play a role in the fall weakness. He cites a five-year-old tax rule that requires portfolio managers to realize capital losses before the end of October if they want to offset the fund’s capital gains in the same year. “If a manager was thinking about selling certain stocks anyway, he might want to do so by Oct. 31,” Norwitz says.

Assuming you plan to bail out of a fund now or in the weeks ahead, keep one more important tip in mind: Before selling shares, elect a method for figuring the taxable gain or loss.

The IRS allows three main choices for making this calculation, and you can select the one that minimizes your reportable gain or maximizes your deductible loss. You can choose only one method for a particular fund, although you can use different approaches for others. It’s a good idea to document your selection by writing a letter to the fund company at the time you redeem, Weitz says.

If your fund has dropped in price since you’ve owned it, you might want to select the FIFO--or first-in, first-out--method. This way, assuming you don’t liquidate your entire account, you would sell your earlier, more expensive shares first, thereby creating a larger loss (or smaller gain) for tax purposes. Usually, however, prices rise over time, which makes specific-identification a better bet. Under this method, you would choose to sell your more expensive shares first--regardless of when purchased--and thus minimize your tax bill.

Under the third method, you simply average the cost of all your shares and go from there. Though not necessarily advantageous, you might have to follow this procedure if you don’t keep good records of when you previously bought and reinvested, Weitz warns.

A few fund companies have started to provide average-cost calculations for their investors. Norwitz likes the idea, because it makes record-keeping easier for many people. “Mutual fund accounting is complicated enough that it might even discourage some investors from redeeming shares,” he says.

Danger Ahead?

You might want to hold off for a few weeks on new investments in equity mutual funds. You could face a higher tax bill if you purchase shares before a year-end capital gains distribution. Besides, the market historically has tended to get blown off course from roughly mid-October to mid-December, then rally in subsequent weeks.

The average results for the Dow Jones industrial average during the past 20 years shows that for the period of Oct. 15 through Dec. 15 there is an average loss of 0.7%; for Dec. 16 through Feb. 15, an average gain of 4.4%. There’s no assurance that stocks will continue to move in this manner, of course, but the trend has been for a late fall decline followed by a New Year’s rally.