Watch Out for Mutual Fund Tax Bill That Punishes Late-Year Investing

By: Jeff Brown

NEW YORK (BankingMyWay ) — All in all, 2014 has been a decent year for stocks and stock funds. Not as great as 2013, but good. Now for the downside: Mutual fund investors need to watch out for an unexpected, and in some respects undeserved, tax bill — a matter to consider in any investments made between now and the end of the year.

The issue involves tax on year-end capital gains distributions. This can hit any fund investor, but it’s especially nasty for those who invest late in the year. They can end up owing tax on gains they didn’t actually enjoy, and the risk is especially high after the stock market has done well. That’s the case now, with the Standard & Poor’s 500 gaining nearly 10% this year on top of 32% in 2013.

Capital gains tax applies to an asset that is sold for more than was paid. If you bought a stock a few years ago for $100 a share and sold it this year for $150, you’d be taxed on the $50 gain. That would cost $12.50 if you were in the 25% tax bracket. (This applies to ordinary taxable accounts. not tax-deferred accounts such as IRAs and 401(k)s.)

It works the same way for a mutual fund. Near the end of the year, the fund tallies the gains and losses on stocks or other holdings sold during the year, and any net gains are paid out to the fund’s investors. These payments are easy to overlook because many people have them automatically reinvested in more fund shares, but they are taxable nonetheless.

Unfortunately, the distributions don’t make the investor any richer, because the fund’s share price drops simultaneously to reflect the payout. So if a $150-per-share fund distributed $50 a share, the share price would drop to $100. The investor who had owned just one share would still have $150 in assets, only now it would be divided between the $100 share and the $50 in cash. But the $12.50 tax bill on the payout would reduce the total value to $137.50.

If you’d owned the fund for some years and seen your shares rise from $100 to $150, you could shrug this off because, after all, profits do trigger taxes. But if you bought the shares just before the distribution, paying $150 each, the $12.50 tax bill could seem like a raw deal, turning your holding into a money-loser overnight.

How can you avoid this?

The first step is to check the fund’s potential capital gains exposure before investing. This figure, found under the tax button on fund listings at Morningstar . the investing-data firm, shows the percentage of the fund’s share price attributed to unrealized capital gains. The higher the percentage, the bigger the risk.

A potential exposure becomes an actual exposure only after the fund manager sells holdings, and sales of money-losing holdings can reduce the net profits from the winners. Also, the manager may hold on to many of the winners, keeping them from adding to any distribution that year.

So a second step is to look at the fund’s turnover, which is a percentage of the fund’s assets that are shifted from one holding to another during the year, a move that involves sales. The higher the turnover percentage, the more likely the fund will have a large distribution, especially if the markets have done well.

Third, consider the overall market conditions. If a fund has net losses on assets sold rather than gains, it can carry them over to offset gains in future years. Since stocks have done well for the past few years, it’s less likely a fund can minimize gains with carried-over losses this year.

Finally, visit your fund company’s website often. Many funds will start listing estimated capital gains distributions in the next month or so. If a fund you want is poised to make a big distribution, buy it at the lower share price after the distribution is complete.

If taxes on big distributions are a problem year after year, consider changing your investing style. Actively managed funds, which seek the hottest holdings, tend to have high turnover, which can trigger big distributions. Index-style funds and exchange-traded funds  have low turnover, because they hold their assets for the long term. Also consider tax-managed funds. Although actively managed, they try to minimize taxes with strategies such as selling losers to offset winners.

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