A Hazardous Time to Invest in Mutuals Funds

The end-of-year mutual fund tax trap is a particular risk this year, with many portfolio managers sitting on huge profits. Indeed, the Markman MultiFund Trust of Minneapolis will make a highly unusual--if not unprecedented--move Nov. 1 when it temporarily shuts its doors to new investors to protect them.

Portfolio manager Robert Markman says he doesn’t want shareholders to unwittingly expose themselves to a potential tax liability by buying shares shortly before one of the Markman funds pays a capital-gains distribution. Federal law requires fund companies to make such distributions each year on stocks sold at a profit.

These payments are undesirable because they are taxable yet don’t increase the wealth of shareholders. Actual gains as well as paper gains already are reflected in a fund’s daily per-share price, so receiving a distribution doesn’t help.

“Your account won’t be worth any more the day after a distribution, but you will have a tax liability,” Markman says.

Long-term investors should expect to shoulder their share of the tax bite on a fund’s profit, of course. But unwary new shareholders can also get stuck with a tax bill for gains in which they didn’t participate.

“You don’t want to invest on Dec. 15 and get hit with a tax bill five days later,” says Ken Gregory, co-editor of the No-Load Fund Analyst newsletter in Orinda, Calif.

Capital-gains distributions usually come in November or December, which makes investing this time of year hazardous. They sometimes can be quite large, reflecting profits on stocks bought many years earlier at much lower prices.

If you get caught in this trap, you can wiggle out when you sell the because the distribution changes your “basis.” In other words, if the fund goes up you won’t have to pay taxes on the part of your capital gain that equals the distribution this year. And if the fund goes down in price, you have a larger loss to offset other capital gains. However, it’s always a disadvantage to pay taxes too, because the money can’t earn interest or work for you in the meantime.

Investors will be discouraged from buying shares in the three stock-oriented Markman funds in November or December; cash sent in during those months will be placed in a money-market portfolio until Jan. 1. This prohibition won’t apply to purchases made in individual retirement accounts or other tax-sheltered plans, for which the capital-gains issue is a moot point.

The three no-load Markman portfolios ([800] 707-2771) invest in various combinations of other mutual funds. They require a $25,000 minimum investment unless bought through selected discount brokerages.

The unusual fund-closing maneuver by the Markman group is a reminder of the pitfalls of investing late in the year.

Investors owe taxes on capital-gains distributions, whether they take the payments in cash or reinvest in new shares. For people who reinvest, it’s important to maintain good records to avoid paying taxes a second time down the road on the reinvested amount.

Suppose you sell a $25,000 position in a mutual fund, on which you started with a $10,000 purchase and reinvested $5,000 worth of dividend and capital-gain distributions over the years. Since you already paid taxes on the reinvested amount, you would owe remaining taxes on a $10,000 gain, rather than the $15,000 increase, provided you have adequate records.

In short, if you’re pondering a fund purchase over the rest of 1995, heed the following guidelines:

* Call the fund company to find out when the distribution will be declared and wait at least one day after the “ex-distribution” date. Keep in mind that by waiting, you might miss out on a short-term rally.

* Ask the fund company how big the distribution will be. A fund’s net payout might be small or nonexistent if the manager offsets profits by taking losses during the year. A few mutual funds actively try to reduce their net taxable gains in this manner.

* Hold mutual funds inside of individual retirement accounts, variable annuities, 401(k) plans and other sheltered accounts, for which there’s no near-term tax impact. Alternatively, hold tax-efficient funds, such as index portfolios, which distribute little in the way of capital gains because they rarely sell off holdings.

Markman says he decided to restrict late-year purchases after analyzing information compiled by the Investment Company Institute in Washington. The data showed people continue to buy mutual-fund shares for taxable accounts in November and December.

“Investors are warned over and over about this, yet they’re basically not heeding that advice,” Markman says. “The bottom line is that you won’t get rich paying taxes on gains you never earned.”

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The Montgomery Select 50 Fund finally opened to investors on Oct. 2 after a three-month delay, attracting $4 million in its first week.

The fund follows the unusual approach of mixing roughly 10 favored stock picks from each of five analyst teams at Montgomery Asset Management of San Francisco. The five teams concentrate on small stocks, growth stocks, income shares, foreign stocks and emerging foreign markets.

There are no sales charges on Montgomery Select 50 ([800] 572-3863), for which the minimum investment is $1,000.

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Liberty Financial Cos. of Boston is offering a free interactive computer game to teach youngsters about money and investing. Players earn points by correctly answering questions while moving around an electronic game board. Topics include risk, taxes, mutual funds, financial planning and the economy.

Call (800) 403-KIDS for a copy of the “Young Investor Game,” which runs on IBM-compatible machines with DOS 3.3 or higher, or Windows 3.1 or higher.

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The Salomon Bros. Fund, a closed-end portfolio that trades on the New York Stock Exchange, says it will repurchase up to 1 million of its shares in the open market to help reduce a discount that has been running around 19% lately. As another means to cut the discount, management will make dividend payments in shares rather than cash to investors enrolled in the fund’s automatic dividend-reinvestment plan.

The fund, headquartered in New York and operating since 1929, primarily owns large U.S. stocks.

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The Teachers Insurance & Annuity Assn. of New York, part of the world’s largest pension system, has unveiled a real-estate variable-annuity account for members.

“Real estate is an important basic asset class in a retirement investment portfolio and a valuable diversification tool,” said John H. Biggs, chairman and chief executive of TIAA-CREF, which manages $150 billion for employees at education and research institutions. Most of the real estate holdings will be direct investments in commercial properties, supplemented by high-quality bonds and other debt securities.