Know the Risks of Year-End Mutual Fund Purchases
When it comes to investing, most experts offer the same advice: If you are a typical mutual fund buyer saving for college or retirement, don't try to time the market. It's a loser's game.
Except that you might tweak your timing a little -- just a little -- at the end of the year, or you may get hit with a tax bill on year-end capital gains distributions that you don't deserve. Because stocks have done well in recent years, many funds are sitting on large profits that could create big tax bills.
"Many mutual funds are expected to make sizable capital gains distributions this year," says Mike Piershale, president of Piershale Financial Group in Crystal Lake, Illinois. "Some funds are paying out gains for the simple reason that the securities hit the manager's price targets."
Other funds, he says, trigger taxes by selling profitable holdings to pay cash to shareholders who are pulling out, disappointed by this year's lackluster results, or who want to move to funds less likely to trigger big year-end tax bills in the future.
"This has triggered capital gains in a year where the stock market has not done that well," he says.
What are year-end distributions? Year-end distributions are payments to investors of any profits earned on holdings like individual stocks or bonds that the fund managers sold during the year. If the fund is held in a taxable account, the distributions are taxed as long- or short-term capital gains. Of course, there's no tax if the fund is in a tax-favored account such as an IRA or 401(k).
The tax is owed even if you use the distribution to automatically buy more shares of the fund. That means you may have to dig up cash from somewhere else to pay the tax.
Although there are no industrywide figures yet for this year's distributions, Morningstar, the market-data firm, predicts that many funds will make "sizable" payouts, in a few cases amounting to 25 percent of a fund's net asset value, or share price.
If you've owned the fund for some time, you might be philosophical about these distributions. After all, they are profits, and that's what investors want. But if you invest in the fund just before the distribution is made, you'd pay a tax even though you hadn't owned the fund long enough to share in those gains.
Imagine, for example, that the fund started the year at $8 a share, and held stocks that soared, driving its price to $10 a share by the time you invested on Dec. 1. You wouldn't have enjoyed that $2 gain. Now suppose the managers sold those winning stocks and paid out $2 a share on Dec. 15. You'd get $2 for every share you owned, but your share price would drop back to $8, reflecting the cash removed from the fund's holdings. You wouldn't have lost money, but you'd have to pay tax on the $2.
That could be 30 cents a share assuming a 15 percent tax rate on long-term capital gains. It could be higher if some or all of the $2 came from short-term capital gains, for investments the fund had held for a year or less, because short-term gains are taxed at income tax rates as high as 39.6 percent.
Joseph P. Kalmanovitz, director of advisory services at Stonegate Capital Advisors in Scottsdale, Arizona, notes an especially unwelcome possibility: having to pay tax on a distribution even though the fund has lost value during the year. "The reason this can occur is because even if a fund's net asset value has declined during the year, the fund manager may have sold appreciated securities that have been in the portfolio a long time, and those gains still must be distributed to shareholders at the end of the year," he says.
Avoiding tax on distributions is simple. Postpone your purchase until after the distribution is paid out. You wouldn't get the $2 payout, but you'd buy the shares for $8, so you'd lose nothing.
Most fund companies offer estimates on their websites of the payouts they are likely to make on each fund this year. So check before deciding what to do. Look for the record date; if you own the shares on or before that date, you will receive the distribution.
Going forward, savvy investors consider year-end distributions when they decide which funds to buy. Payouts are triggered only when gains are "realized," which is when a profitable investment is sold. The risk of big payouts can be gauged by looking at the "unrealized" gains reported by the fund. Those are profits on holdings that have gone up and have not been sold, but could be.
Some funds have a history of big payouts. Actively managed funds can have large payouts because managers buy and sell frequently in their search for the next hot stock. This is reflected in high "turnover" rates reported in fund documents.
Passively managed funds -- index funds -- tend to have small payouts because they don't sell holdings very often. Instead, they simply buy and hold the stocks in a benchmark index, such as the Standard & Poor's 500 index. "Since index funds are cloning an index, they have less trading, which triggers a lot less tax," Piershale says.
Exchange-traded funds generally do not have distributions. ETFs are like mutual funds that are traded like ordinary stocks. Most are index products, and any gains they realize from sales are simply reflected in the share price.
To deal with the tax issue, some fund companies offer "tax managed" mutual funds that use various strategies to minimize distributions. For example, the fund managers may sell money-losing stocks to offset the gains on the winners they sell. Then, if they think the losers may rebound, they might buy them back
Put your IRA or 401(k) to work. For individual investors, another strategy is to use a tax-favored account like an IRA or 401(k) for any fund likely to make large year-end distributions. That way, the tax bill is postponed until you redeem your shares, which may not be for many years.
Experts, of course, will tell you not to let the tail wag the dog: Don't avoid a promising investment just because you'll be taxed on the gains.
"Equity mutual fund investors should put much more weight on the long-term direction of the market than on potential tax liabilities arising from near-term distributions to shareholders," says David Louton, finance professor at Bryant University in Smithfield, Rhode Island. He notes that because stocks often do well in January, investors should not wait too long after the record date to make their purchases.
Experts will also tell you to keep good records. That's because your distributions, if you reinvest them, are not to be taxed again when you eventually pull money out of the fund. In effect, the distribution is added to the "cost basis," or average price paid per share. A higher cost basis reduces the profit when you eventually sell the shares, so your tax bill will be smaller.
Most fund companies update each investor's cost basis automatically when distributions are reinvested, so it should be easy to figure the taxable gain after you redeem shares. But for safety's sake, keep the year-end statements that report these distributions. Those will come in January.Jeff Brown spent nearly 40 years as a newspaper reporter, columnist and editor, including 20 years writing about investing, personal finance, the economy and financial markets. He spent 20 years at The Philadelphia Inquirer and has been freelancing since 2007.