Tax Bite Likely to Stimulate Demand for IRAs

A few things are happening these days that add a little excitement to what’s normally a pretty dull subject: mutual fund taxation.

Some fund experts predict that a universally deductible individual retirement account will make a comeback under Bill Clinton, especially since the President-elect has chosen Sen. Lloyd Bentsen (D-Tex.), an avid IRA backer, as Treasury secretary.

Last year, Bentsen co-authored legislation that, among other things, would have made a fully deductible IRA available to all taxpayers, as was the case from 1982 through 1986.

Currently, IRA deductions aren’t allowed to higher-income workers covered by company pension plans. They can still invest in IRAs without the write-off. But non-deductible IRAs, which do offer tax-deferred growth potential, don’t seem to be much of a hit.

“My feeling is that most people don’t even think (non-deductible IRAs) exist,” says Jon S. Fossel, chairman and chief executive of Oppenheimer Management Corp., a New York fund group. He predicts some type of universally deductible IRA will return, given Bentsen’s record and Clinton’s desire to stimulate investment.

IRAs might soon become more popular among mutual fund investors for another reason.

Starting Jan. 1, anyone taking a lump-sum distribution from a company pension plan will be subject to a 20% tax withholding on the money received, unless they transfer the cash directly into an IRA (or switch it into a new employer’s pension plan).

This new law affects people who retire, quit or get laid off and elect to cash out of their former employer’s plan in a lump sum. The 20% withholding isn’t a new tax, but it could result in your paying tax earlier than might otherwise be the case.

In effect, it could increase your 1993 income tax liability and permanently remove some of your assets from a sheltered account. It might also subject you to a 10% penalty for a premature withdrawal from a retirement plan, assuming you’re under age 59 1/2.

You can avoid the tax trap by arranging to have your retirement-plan assets directly transferred (rather than rolled over) to an IRA. Nearly all fund companies can handle such transfers, as can many other financial institutions.

A money-market fund could be a good transfer destination assuming you want to avoid the withholding but don’t yet know what to invest in. You can later switch into stock or bond portfolios offered by the same fund group.

“That’s always my advice anyway--make the move into a money fund first, then take the time to make your investment choices,” says Daniel P. Wiener, editor of the Vanguard Adviser newsletter in Boston.

From a tax standpoint, investing in a mutual fund outside of a tax-deferred account such as an IRA is trickier than purchasing individual stocks or bonds. Not only must you pay taxes on any capital gains arising when you sell shares, you also might face a liability each year on profits resulting when the portfolio manager sells stocks from the fund’s holdings.

Most funds declare such gains in December, which makes year-end investing somewhat hazardous. When a fund declares a capital gain distribution on what’s known as the ex-distribution date, the price drops by the amount of the payment.

“If you buy just before the distribution you will find yourself paying taxes on profits you didn’t earn,” notes Sheldon Jacobs, editor of the No-Load Fund Investor newsletter in Hastings-on-Hudson, N.Y. He suggests calling the company for distribution dates before making December purchases.

As noted, this advice wouldn’t apply to people investing in mutual funds through IRAs or other tax-sheltered plans. Nor would it pertain as much to bond funds, which pay dividends in smaller increments on a monthly basis and typically don’t have large capital gains.

But on stock funds not held in a sheltered account, the amount of the distributions would be taxable to all current shareholders, even if you bought just days before the payment was declared. And it doesn’t matter if you took the distribution in cash or simply reinvested the proceeds in additional shares--you would still owe Uncle Sam. Eventually, when you sell the fund, you would be able to recoup the amount paid in taxes--assuming you remember about it.

That’s why it’s important to keep good records, so you can raise your adjusted cost or “basis” by the amount of taxes paid along the way on reinvested shares. This allows you to reduce any resulting capital gain or increase any loss.

It’s worth noting that funds typically declare capital gains even in years when their returns are modest, as in 1992. That’s because the portfolio manager may have sold stocks or bonds in 1992 that were purchased at much lower prices in previous years.

“The manager might be selling a stock he bought back in 1972,” says Wiener. “By waiting to purchase until after the distribution, you avoid the distribution and get to buy more shares at a lower price.”