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Archive for Sunday, October 5, 2003

Down market still produces tax liabilities

October 5, 2003

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Every year about this time, investors get a standard warning here: Beware of mutual fund purchases in the coming months, else you could inherit a tax bill for profits you never received.

But does this matter anymore, given the stock market's decline of 2000-2002. Yes.

Because of recent stock-market gains, investors are pouring billions into stock funds so many people are risking tax headaches.

"This year you have to look at your funds category by category," said Kunal Kapoor, associate director of fund analysis at Morningstar Inc., the fund-tracking company. "There are going to be some distributions, but they are not going to be of a large magnitude."

Federal law requires that funds pass on to shareholders the net profits made during the year when the fund manager sold stocks or other assets held in the fund. Profits must be paid to investors by the end of the year. Most funds make this "capital gains distribution" in November or December.

Most long-term investors have the distributions automatically reinvested in more fund shares, so they never get a check. But the distributions are taxable unless the fund is held in a tax-deferred account, such as a 401(k) or IRA.

Imagine you buy your fund shares for $10 each -- a price based on the value of the fund's holdings divided by the number of shares held by investors.

Suppose the holdings include stocks that have gone up in price and are then sold. The cash is still in the fund, so the sale has no effect on the fund's price.

At the end of the year, however, the fund must distribute any net profit from all its sales. If the fund sent investors $1 per share, the drop in assets would cause the share price to drop to $9.

So here's what could happen: Just before the distribution, you invest in the fund at $10 a share. After the distribution, your shares are worth $9 each and you have cash equal to $1 per share (or some new shares, if the cash were reinvested).

Your net worth stays the same: $10 for every share you'd owned. But you owe a tax on the cash you received or reinvested. Assuming it's all long-term capital gains, it would be 15 cents per share -- 15 percent of $1.

If you'd invested $10,000, your holding would now be worth $9,850. And if the distribution had been $3 for every $10 share, your $10,000 investment would now be worth $9,550.

For investors who had owned the shares a long time, the tax bill makes sense. If they bought the shares years earlier, before those stocks soared, they might have paid $7 a share and enjoyed the rise to $10. It's only fair they be taxed on the $3 gain. But if you bought this fall at $10, you'd be stuck with a tax on profits you never enjoyed.

In 2000, ordinary investors with taxable accounts received a record $96 billion in capital gains distributions, according to the Investment Company Institute, the fund-industry trade group. After three years of declining stock prices, that figure shriveled to $5 billion in 2002.

Morningstar's Kapoor says this year's industrywide distributions are likely to be closer to the 2002 number than the 2000 one, but some funds may nonetheless make very large payouts, since stocks have rebounded this year.

Those include funds that invest in small-company stocks and bonds, and emerging-market bond funds that invest in bonds from developing countries, he said. Some high-yield bond funds may have large distributions as well.

It would be a shame to postpone a promising investment out of tax concerns and to miss a big price gain during the next few months.

But the tax issue is worth considering. Call the fund company to see if there's an estimate of distributions. Fund companies will start making this information available this month.

Ask about the fund's "realized gains," which means profits accumulated during the year that could produce distributions after the fiscal year ends, usually in October or November.

Also ask for information about pretax and after-tax returns in previous years. The bigger the difference, the bigger the tax bite, though previous years' experience won't necessarily be repeated.

Then take a look at portfolio turnover -- the percentage of the fund's holdings that are bought and sold every year. Funds with lots of turnover -- say 50, 80 or 100 percent -- will make large distributions if they realized lots of profits.

Also look up the fund on the Morningstar Web site at www.morningstar.com. Call up the fund and click on the Tax Analysis button to find lots of information on how taxes on distributions have cut into returns.

If you find a fund you like but worry about inheriting a big tax bill, ask the fund company for the "record date." Investors who own the shares on that date receive the distribution. By postponing your investment until after that date, you'll avoid the distribution -- and escape this onerous tax.

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