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How to Mimimize the Pain of a Fund's Capital Gains Distribution
Sometimes, your timing is bad and you buy a mutual fund near a peak.
Late in the year, you've got a 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.
2000 and 2001 were different: Some of the hottest funds plunged--but they still made taxable capital gains distributions.
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:
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Q: 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.
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Q: 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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Q: Who really needs to worry about distributions?
Capital gains payments could be of most concern to investors whose investments 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 early in the year. Those investors who sold out of the fund in spring may have caused the fund manager to sell stocks to cash them out.
Then late in the year, those investors who still own the fund may be getting the gains realized last spring--even though the fund itself has lost value since. Such is the nature of the mutual fund structure.
A fund with a recent history of big unrealized gains, then substantial shareholder redemptions, can be a prime candidate for a potentially large distribution.
However, note that the distribution does reduce your "tax basis". You won't have to pay taxes twice. (See the last question and answer.)
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Q: 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 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.
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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Q: 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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Q: 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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Q: 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 an immediate expense for you.
If it's a question of paying now or paying later, a lot of people would naturally prefer to pay later.