Yes, with the year two-thirds over, it's time to wag my finger again about tax-preparedness and investing and to warn that last spring's stock-market plunge makes year-end tax planning particularly important this time.
Decisions you make over the next few months could have a big effect on your tax bill come April.
Year-end tax planning usually is based on one guiding principle: You'll probably have to pay tax on investment gains someday, but better later than sooner. The longer you can avoid paying taxes, the longer you can keep that money invested and growing.
The year you sell a profitable investment, you trigger a tax on the gain at the 20 percent maximum capital gains rate if you'd owned the investment for more than a year. So the easiest way to hold off a tax bill is to hang on to the investment.
That's not a good strategy, however, if the investment no longer is promising and the money could grow faster somewhere else. Then it's best to sell and face the tax.
Fortunately, the tax on that gain could be reduced or eliminated if you sold another investment at a loss. That loss then would be subtracted from the gain on the first investment, and you'd be taxed only on a "net" gain.
So between now and the end of the year, smart investors will re-examine their holdings, seeking and selling losers that don't seem likely to rebound.
Looking for value
Often, an investor who has accumulated a large block of shares over time in a single stock or fund will find that although many of the shares have gone up in price, those purchased during peak periods have fallen. In that case, you might capture losses by ordering your broker or fund company to sell only those shares that are trading below the purchase price. Talk to the broker or fund for instructions.
Now to the special mutual fund problems.
Even though you have not sold your fund shares, you will be taxed on annual dividend and capital gains distributions. By law, fund companies must pass on to shareholders the dividends earned each year by stocks owned by a fund. Funds also must distribute the net profits from stocks or other holdings the fund manager sold during the year.
Many investors have this money reinvested in fund shares, but the tax is due anyway. The gains will be reported on the 1099 forms you will receive from fund companies and brokerages in January.
This year, many fund managers undoubtedly unloaded some holdings to avoid losses as stocks hit the skids early in the year. Nasdaq stocks, for instance, fell 37 percent from early March to late May.
In some cases, fund managers may have been forced to sell stocks to raise cash when nervous investors redeemed their fund shares. Many of these sales may have locked in sizable profits, thanks to the big stock gains of the late '90s. These profits, less any offsetting losses, in most cases will be distributed to fund shareholders in November and December.
An extreme example so far is the Warburg Pincus Japan Small Company fund. Investor redemptions earlier this year forced the fund to sell stocks that had toted up large profits. The resulting $7.88-per-share distributions, made last month, equaled more than 50 percent of the fund's share price at the time. Thus, shareholders will be hit with whopping tax bills even though the fund has lost money this year.
Many other big distributions are likely to be lurking. Most funds won't know for another month or two just how much they'll distribute, so it's tricky for investors to plan. But it might make sense to lock in losses on any investments you were thinking of unloading.
If, at the end of the year, you don't have gains to offset, the losses can be used to reduce up to $3,000 in regular income, cutting your income tax. Losses beyond that can be carried forward and used later.
Balancing gains and taxes
It also makes sense to be cautious about investing in funds this late in the year, as you could inherit a tax bill. There's no benefit to receiving a distribution because once it is made the fund's share price drops to reflect the fact that money has been drawn out of the fund. So what you gain in distribution you lose in fund value, though you still get stuck with the gains tax on distributions.
It's better, therefore, to hold off the purchase until after the distribution. Your money will buy more at a lower price, and you'll avoid this year's gains tax. Of course, you need to weigh this benefit against the potential cost of waiting. You'd miss out if the share price rose in the meantime.
While it's too soon to know what every fund will distribute, there are some warning signs. Funds that usually have a lot of turnover that is, they buy and sell a lot often have larger distributions than funds that buy and hold, such as index funds.
Also, funds that changed managers or investment strategy are likely to have sold many profitable holdings, triggering distributions. And a fund that had a big decline in its total value may well have had to sell holdings to meet shareholder redemptions.