Gain Drain : Beware: Buying In Now Could Add to Tax Load

No one likes getting a tax bill, but imagine being taxed on profits you never saw.

It happens to many investors who buy mutual funds late in a high-performance year. So if you plan to invest in a fund between now and year’s end, be aware.

By law, mutual funds must pass 98% of their capital gains to shareholders by year’s end or face excise taxes--which would hurt returns. Most make that payout in late November or December.

If you invest before that payday, you get the capital gains distribution and the tax bill that comes with it, even though the fund accrued most of those gains before you bought in.

It doesn’t mean you made any money. An investor with $10,000 in a fund who receives a distribution and reinvests it will still have $10,000.

“A lot of people think it’s a wonderful thing to buy a fund and almost immediately get this gain distribution,” says Anne M. Lieberman, who runs Lieberman Associates, a San Rafael, Calif., investment advisory firm. “Some people even think they should hurry up to get in on it and never realize that getting this dividend right away is actually harmful.”

“The irony,” says James P. Owen, managing director at NWQ Investment Management in Los Angeles, “is that you can actually be pretty severely penalized and forced to pay taxes on gains you didn’t receive.”

Distributions can be sizable. The biggest ever in dollar terms was paid out in May by Fidelity Investments’ flagship Magellan Fund. The distribution included $10.20 a share in long-term capital gains, $2.65 a share in short-term capital gains and 50 cents a share in income, Fidelity said.

The distribution was tied to gains the fund made between Nov. 1 and March 31, Fidelity said. Most of the gains were made in late 1995 when former manager Jeffrey Vinik sold off a “significant number of technology stocks,” the company said. Magellan generally makes two distributions a year, one in May and one in December.

Here’s how it works:

Say you invest $5,000 in a fund in which the current share price reflects a 12.5% unpaid capital gain.

When that gain is paid, you get a check for $625, about a third of which--$200 or so--will be owed to the tax man.

The net asset value of your shares, meanwhile, drops by the per-share amount paid out to you. In essence, you get some of your own money back so that you can pay taxes on gains earned by the fund’s other investors. It doesn’t matter if you immediately reinvest the gain, which is what most people do.

Although it’s a tax hit now, it is also true that if you sell the fund at a profit in the future, you won’t have to pay taxes on the amount of the distribution again, or if you sell at a loss it adds to your loss. But it is never a good idea to pay taxes too early.

The tax problem doesn’t affect tax-sheltered accounts and retirement plans, where gains grow tax-deferred until the money is withdrawn. And this isn’t much of a problem in index funds--which rarely sell--or any fund that hasn’t sold many stocks at a gain this year.

In addition, the year-end payout is not much of a concern in most bond funds, since they pay income and dividends more regularly and avoid the yearlong buildup.

And of course the tax consequences won’t matter much if you’re convinced the fund will skyrocket.

The rule, then, is to weigh the potential tariff against the immediate short-term growth prospects of the fund. That’s a delicate balance, given that experts generally believe that taxes should not be the dominant factor in most investment decisions.

If you are considering purchasing a mutual fund for a taxable account, call the fund family and ask what gains the fund has realized this year. Many fund groups will issue year-end gains estimates--based on current gains plus anticipated maneuvers by the end of the fiscal year--in the next month.

Each fund has individual circumstances that can affect your decision. Remember, too, that the numbers and the estimates are fluid and can change right up to payday.

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For most investors, the tax bill will not be significant unless the planned investment is a few thousand dollars. Experts warn against disrupting automatic deposit plans just to do a few bucks better in taxes; it’s simply not worth the hassle to save, say, the cost of a pizza.

To figure out the tax bill on a year-end fund investment, divide projected gains by the current share price. The result is a fraction that, when multiplied by the amount of your new investment, will tell you how much money the fund is about to return to you. About a third of what you get back, thanks to state and federal taxes, will wind up with the government.

It’s up to you to decide whether the dollars involved make it worth postponing a purchase. At the very least, run the numbers. If the tax bill would be hefty and you don’t believe the fund will shoot the moon in the next two months, plan to buy one day after gains are paid.

Despite warnings, the level of fund buying by individual investors doesn’t usually slow at the end of the year.

Charles A. Jaffe is mutual funds columnist at the Boston Globe. Bloomberg Business News also contributed to this column.