Here it is, the tail end of the year on its way time for the usual warning about the unexpected tax bills that can lurk in autumn mutual fund purchases.
Except that the danger might not be as dire this year, thanks if you can put it that way to the crummy stock market.
"It should be much less of a problem," says Russ Kinnel, director of fund analysis for Morningstar Inc., the Chicago fund-tracking company.
This annual issue involves net gains from stocks or other assets that a fund manager sold during the year. If profits outweigh losses, the net must be turned over to investors by the end of the year. Although most investors automatically reinvest distributions in more fund shares, the payments are, nonetheless, subject to tax. The exception is an investment held in a tax-deferred account such as an IRA or 401(k).
Last year, the result was particularly brutal. Capital gains distributions to ordinary investors with taxable accounts came to a record $99 billion, up from $67 billion in 1999 and $49 billion in 1998, according to the Investment Company Institute, the fund industry's trade association.
Distributions can be taxed at short-term capital gains rates as high as 39.l percent if the assets sold had been held in the fund for a year or less. Distributions of profits on assets held longer than a year are taxed at the long-term capital gains rate of 20 percent.
Last April, many investors were shocked to find they owed tax on year 2000 distributions even though the overall value of the funds involved had fallen. That's because capital gains had been realized by fund managers who sold assets to lock in profits late in 1999 or early in 2000, before the market fell into the dumps. Afterward, the value of many funds' remaining assets fell. But unless an investor sold the fund shares, those were just paper losses that had no effect on taxes.
Why is the problem less acute this year?
"For obvious reasons," Kinnel said, "there's a lot less profit to distribute, unfortunately."
Stock funds drop
Distributions involve net profits realized during the fund's fiscal year, as well as those realized in the current calendar year through Oct. 31. The stock market downturn began during the first quarter of 2000, so there hasn't been a big rush to lock in profits this time around.
Since the start of this year, the average stock fund has lost about 12 percent, according to Lipper Inc., the fund tracker.
That doesn't mean there will be no distributions. A stock that fell in value this year and was sold still may have shown a profit if it was bought cheaply back in the '90s or earlier. About 8.4 percent of diversified U.S. funds have made distributions so far this year, compared to 14 percent at this point last year, Morningstar says. The value of the average distribution has fallen by about half since last year, to a little more 2 percent of the fund's assets.
Still, it would be a shame to invest in a fund this fall and then have to pay tax on profits from which you did not benefit. That would happen, for example, if you bought 100 shares at $10 apiece, then received a $2-per-share distribution the next day. You would owe tax on the distribution. But the share price would fall to $8 because the $2 distribution would reduce the fund's "net asset value" the total value of fund holdings divided by the number of shares in existence. In other words, your investment would still be worth just $1,000 $200 in distributions and $800 in shares. To benefit from the profits represented in a distribution, you must own fund shares during the time the profits grew.
To avoid the tax on a distribution, you can postpone the investment until after the payment is made. Instead of buying 100 shares at $10 each, you'd buy 125 at $8.
Postponing a fund purchase for the next three or four months means, of course, that you'd risk missing out on any rise in share price that could occur while you waited. You'd kick yourself if you did that only to find there was no distribution after all.
Check the results
Fortunately, investors don't have to fly blind not completely, anyway. By late September or early October, many fund companies can provide estimates of distributions to be made by the end of the year. You can get them by phoning the company or in some cases by checking its Web site.
If distribution data is not available, ask about the fund's "unrealized" gains or losses. These are the net profits or losses that would be triggered if the fund sold all its holdings. The figures come from funds' annual reports, so they may be pretty stale. And unrealized gains or losses don't turn into taxable distributions until they are "realized," which happens only when holdings are sold. Even a fund with large unrealized losses could trigger a taxable distribution if it sold just its profitable holdings.
Still, the odds of avoiding a big distribution are better if the fund does not harbor large unrealized gains. Data for individual funds' potential capital gains exposure is available on Morningstar's Web site, www.morningstar.com. Key in a fund's ticker symbol and look at the tax analysis section.
Kinnel suggests that investors also look for other distribution risk factors. Funds that have changed managers during the past year or have significantly changed their investment strategies are more likely to have sold off holdings and triggered distributions. Big sales are also likely with funds that have been forced to raise cash to meet share redemptions when large numbers of investors pull out.
As I said, the falling stock market should reduce the size of distributions this year. But it's worth checking anyway.