How to Make Capital Gains Distributions Less Painful at Tax Time

After watching that technology stock mutual fund soar in 1998 and ‘99, you jumped in early this year--right near the sector’s peak.

You’ve got a big paper loss on the investment. Yet your fund now is telling you you’re going to get a taxable capital gains payment for the year--for “gains” you never benefited from.

Ouch. Ouch! Lousy returns and somebody else’s tax bill. Now that’s a double-whammy.

Welcome to the complicated world of mutual fund taxation.

In years past, when mutual funds were routinely racking up annual returns of 20%, 30% or more, the tax bite from capital gains payments may have annoyed investors, but at least they saw their investment advancing as well.

This year is different: Some of the hottest funds have plunged from their winter peaks. Yet they still will be making taxable capital gains distributions.

“I expect there to be some pretty unhappy people,” said Philip J. Holthouse, partner at a Los Angeles tax law and accounting firm. “This is the first year in which a lot of people will have the bad tax answer without the good investment return.”

What are these fund distributions, who needs to be concerned about them, and what can you do to lessen the financial pain?

Here’s a look at the issues:

What are fund capital gains distributions?

Under federal law, mutual funds are required to pay out any net realized capital gains to their shareholders each year. These gains, which derive from stock trades or other investment income, can be short-term or long-term or a combination of the two.

The type of gain, and therefore its tax treatment for investors receiving it, is based on how long the fund held a particular security--not on how long an investor has owned the fund.

For tax purposes, most funds close their books Oct. 31. Typically, they then tally their capital gains situation in November and pay distributions in December. But payments can be made at any time of the year.

In part because of the explosive stock market in the fourth quarter of 1999 and first quarter of this year, financial advisors are bracing for a potential onslaught of big fund distributions this December--many from funds whose fortunes have soured since spring.

“I always call around to the fund companies to find out about distributions, and last year at this time I was getting pretty fair estimates,” said Jennifer Cagle, associate portfolio manager at the Keller Group, a planning and investment firm in Irvine. “But this year I’ve gotten zero response. Our assumption is a lot of them may not have great news.”

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Should I care about distributions if I own my funds in tax-sheltered accounts?

Probably not. If your funds are in tax-sheltered retirement accounts such an IRA, 401(k) or 403(b) account, any payout you get remains tax sheltered.

Even investors who own funds in taxable accounts may just want to continue gritting their teeth and paying the tax bill if they have been in the fund a long time and plan to continue holding it.

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Who really needs to worry about distributions?

Capital gains payments could be of most concern to investors who bought funds in taxable accounts late last year or early this year and now are underwater.

In effect, these investors may be picking up the dinner check for shareholders who already ate and left. Paper gains from stock holdings may have boosted a fund’s share price earlier this year. Those investors who sold out of the fund in spring may have caused the fund manager to sell stocks to cash them out.

Now, those investors who still own the fund may be getting the gains realized in the spring--even though the fund itself has lost value since. Such is the nature of the mutual fund structure.

After the market rally of 1999, investors poured a record $130 billion into stock funds in the first quarter of 2000, much of it in sectors that had been sizzling. In some cases, all these new investors will be getting is a costly lesson in the price of performance-chasing.

Asian stock funds and those from other market areas that have cooled off--such as technology--are particularly ripe for the double-whammy of big distributions in a down year.

A fund with a recent history of big unrealized gains, then substantial shareholder redemptions, can be a prime candidate for a potentially large distribution.

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How can I lessen the damage of a planned distribution?

First, try to find out if you really need to take action: Call your fund company or visit its Web site and check to see if the company is estimating what your fund’s year-end distribution may be, and when it will be paid.

Note that most fund distributions are modest (the vast majority are worth less than 10% of the fund’s net asset value per share). But the bigger your fund portfolio, the bigger the potential tax bite you may face.

If you have a loss on a fund you bought early this year and are facing a substantial distribution, many financial advisors recommend selling the fund before the distribution is paid. The advantage: You can use the loss to offset any realized capital gains in your portfolio, either from individual stocks or from other funds.

Technically, it generally does not matter much whether you sell a fund before or after the distribution when taking a loss--as long as you do it by Dec. 31.

However, the process is simpler if you get out before the distribution, at least in terms of tax paperwork. Plus, you may not know how high the payout will be, so you could be unpleasantly surprised.

Remember that, unlike with distributions, the short- or long-term nature of your capital gain or loss from the sale of the fund is based solely on your holding period.

What if you have a paper gain on a fund this year--is there any reason to sell before the fund pays its distribution, if you were planning to sell anyway? This gets more complicated, because you have to judge the tax implications of your short-term or long-term gain against the makeup of the potential distribution the fund will pay--i.e., how much in short-term gains versus long-term gains.

A long-term gain, remember is taxed at lower rates than a short-term gain.

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If I sell to capture a loss but still like the fund’s long-term prospects, can I buy it back immediately after the distribution without penalty?

Be careful. IRS “wash sale” rules require you to wait 31 days after a sale. If you buy it back sooner the capital loss won’t be allowed.

So the cost of being out of the market for a month must be factored into your decision, since rallies can start any time. Conversely, if you wait 31 days and the market tanks, you could look smart by getting back in on the cheap.

A strategy many planners prefer is to swap into a similar fund immediately. The IRS is cool with that as long as the new fund is not “substantially identical.” Swapping funds that seek to mimic the same index would probably raise eyebrows, but two actively managed tech funds with overlapping holdings would be fine, planners say. Just make sure you’re not dodging one distribution and buying into another.

And don’t use the swap as an excuse to dump what’s cold and buy what’s hot. “I wouldn’t sell a tech fund then buy a real estate investment trust,” said Kurt Brouwer, a Tiburon, Calif., advisor. “Make sure it fits your long-term strategy.”

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If I’m thinking of buying a fund for the first time should I wait until after its distribution?

Yes, unless you are a tax masochist. “Our policy is: No buys after Oct. 1 unless we know the fund has already made its distribution or is not making one,” said Laura Tarbox, a Newport Beach financial planner.

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If I’m getting taxable distributions now, doesn’t that lessen any tax I might pay when I eventually sell the fund?

Yes. Distributions don’t add value to your account like, say, a stock dividend. But they do lower a fund’s share price.

Say you have 1,000 shares of a fund with a net asset value per share (NAV) of $10 today. Your account is worth $10,000.

If the fund makes a $2 distribution per share later this year, the NAV price per share will drop to $8. Assuming you reinvest capital gains (most fund owners do) your $2,000 distribution will buy you more shares, but your total investment value won’t change.

When you eventually sell, however, you’ll pay tax on the difference between the price you paid per share and the sale price per share. That gain may not amount to much, but then, that may be a long way in the future, whereas the tax bill on distributions becomes a 2001 expense for you.

If it’s a question of paying now or paying later, a lot of people would naturally prefer to pay later.

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What Some Funds May Pay Out

Some mutual fund companies have alerted investors to possible year-end capital gains distributions. This chart shows a sampling of funds and a rough idea of what they might pay out--though in almost all cases these are preliminary estimates. The per-share dollar figures listed include short- and long-term gains combined. The percentages are potential payouts as a percentage of the fund’s net asset value per share, or NAV, as of Friday. Also shown is each fund’s year-to-date total return, through Friday.

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Possible capital gains payment per share: Fund YTD Fund in dollars % of NAV return Brandywine $16.06 34.9% +7.3% Fidelity Japan Smaller Cos. 4.65 30.5 --37.2 Fidelity Select Software 27.30 27.7 +7.3 Fidelity Select Dev. Comm. 17.00 25.5 +9.3 John Hancock Large Cap Value 6.70 24.0 +3.3 Janus Venture 20.42 23.7 --29.1 T. Rowe Price Media & Telecom 7.70 22.0 --12.4 T. Rowe Price Intl. Discovery 6.98 20.1 --5.7 Vanguard Explorer 14.91 20.1 +10.9 T. Rowe Price New America Growth 8.47 18.5 --4.6 Fidelity Capital Appreciation 4.75 18.3 --13.1 Fidelity Stock Selector 5.45 17.0 +0.2 T. Rowe Price Growth Stock 6.01 17.0 +6.4 Vanguard Strategic Equity 2.95 16.9 +3.9 Fidelity Utilities 3.70 16.6 --10.6 Putnam Capital Appreciation NA 16.5 --1.0 Putnam OTC Emerging Growth NA 15.5 --26.1 Vanguard U.S. Growth 7.05 15.4 +4.9 Janus Overseas 33.80 15.2 --9.1 Janus Equity Income 23.82 13.9 --4.9 Avg. domestic equity fund +3.3 Avg. international equity fund --15.3

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Note: Check with fund companies for updated estimates. Most of these funds are expected to make capital gains distributions in November or December, except Brandywine, whose distribution is expected this week.

NA: Not available; company estimates percentage payouts but not dollar amounts.

Sources: Fund companies listed, Morningstar Inc.

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Times staff writer Josh Friedman can be reached at josh.friedman@latimes.com.