Don't Let The Taxman Eat Your Lunch
Perhaps you saw the 329% return the Warburg Pincus Japan Small Company Fund posted in 1999 and decided back in January to jump on board. Big mistake: Since then, the fund's value has fallen by nearly 50%. And in August, it dropped the other shoe--right on your wallet. Like some other Japan funds, this one recently sold many of its winning stocks for big gains--gains for which you'll owe taxes next April even though you were not around to enjoy them. The result: For every $1,000 you invested, you got hit with $280 in short-term capital gains, and depending on your tax bracket, you could owe as much as $110 in taxes.
Poor fund returns and big taxable distributions make for a lethal combination--one that lots of mutual fund shareholders will face this year. The average U.S. stock fund is up only 4.3% through Oct. 4, vs. average annual gains of 18% over the past five years. Moreover, Y2K is shaping up to be a banner year for hefty taxable distributions. Already, nine funds have returned 20% or more of their share prices to shareholders, up from none at this time in 1999. An additional 52 have distributed 10% or more of their assets, up from 16 last year, says fund researcher Morningstar. Getting the payout might sound good, but it's not: Unless you hold the fund in a tax-deferred account like a 401(k) or IRA, you must pay taxes on the money. "It's definitely a dangerous distribution season," says Morningstar's Russel Kinnel.
HEADACHES. Whereas value funds were a source of big tax headaches last year, growth funds such as Fidelity OTC and Janus Olympus are topping many financial advisers' watch lists this fall (table). Fidelity and Janus don't have estimates yet. But generally, such funds rode technology into the stratosphere in 1999--and many took profits when the highfliers lost their momentum this year. Growth managers also sold winners to rebalance portfolios that had become dangerously concentrated in tech. "All it takes is for a company to miss one quarter's earnings targets and funds start unloading positions, which generates capital gains," says Thomas Lydon Jr., president of Global Trends Investments in Newport Beach, Calif.
Taxable distributions are one of the biggest drawbacks to investing in mutual funds. Compare the tax consequences of owning stocks with funds. When you buy a stock, no taxes are owed (except for those on dividends) until you sell your shares. With the realization of gains and losses under your control, tax planning is easy.
That's not the case with funds. Fund managers know distributions rankle shareholders, but they have no choice. The law requires that cash from the year's net gains--what's left after taking offsetting losses--be distributed by Dec. 31. Funds can take steps to minimize distributions by practicing buy-and-hold strategies or harvesting losses. Since most fund managers are compensated based on pretax, not aftertax, returns, taxes don't get much attention. To promote disclosure, the Securities & Exchange Commission has proposed requiring funds to publish aftertax returns.
Here's how distributions work: If a $1 billion fund with 100 million shares has $100 million in realized gains, it declares a $1-a-share capital gains distribution. On the distribution date, the fund pays out the $1 per share and reprices the remaining shares at $9 (assuming no change in the value of the underlying portfolio). Most shareholders direct the fund company to reinvest the distributions by buying more shares. So instead of 100 shares at $10 a share, an investor would have 111.111 shares at $9 a share. But to the Internal Revenue Service, it doesn't matter that the investor left the money in the fund. The distribution is a taxable event.
Of course, this is not the only tax paid on mutual funds. Remember, investors also face capital gains taxes when they sell appreciated shares. The annual distributions effectively force fund owners to prepay some of those taxes. Why should you care if you pay a portion of your eventual tax bill early? Because the longer you can put off paying taxes, the more your investment stands to grow. Suppose you invest $10,000 in two funds, each earning 10% a year. One never distributes capital gains, while the other pays out a 10% distribution each year, forcing you to pay the long-term capital gains tax of 20%. If you reinvest what's left of the distributions, and still hold the funds 20 years later, the tax-efficient one would be worth $67,275, vs. $46,610 for its rival, says Joel Dickson, principal at the Vanguard Group.
Still, fund shareholders aren't defenseless. Legislation introduced by Rep. Jim Saxton (R-N.J.) would allow investors to defer paying tax on as much as $3,000 of capital gains distributions each year. For now, though, the best strategy is to get a handle on distributions before they occur. Although most funds notify shareholders of coming distributions--typically in November or December--some have been known to launch surprise distributions to avoid having shareholders bail out ahead of time.
NOT TALKING. The best strategy is to find out what the tax picture looks like for your funds. Some companies make this task easy. Vanguard, for instance, already has posted estimates on its Web site (www.vanguard.com). And for the first time, industry leader Fidelity will publish preliminary figures in mid-October for all of its funds, instead of just the largest ones. Still, most fund companies are loath to talk taxes. They contend that tax liabilities can change sharply as the fiscal year winds down. If you call your fund and no estimates are forthcoming, go to its most recent quarterly report. Look for "realized but undistributed gains," which represent the tax hit that would have been delivered on the day the report was dated, says Richard Bregman, a money manager at MJB Asset Management in New York City. Because these figures are preliminary, remember that your distributions might be different.
If the estimates indicate that you are sitting on a ticking tax bomb, don't panic. Instead, figure out whether you'd be better off selling the fund before it distributes its gains. It helps to know what portion of the distribution reflects short-term gains--or gains on investments the fund has held for less than a year. Whereas long-term capital gains are taxed at a maximum of 20%, short-term gains are subject to an investor's ordinary income tax rate, which can be as high as 39.6%.
Compare that with the taxes you will pay if you say goodbye to the fund before its distribution. If you have a relatively small capital gain in a fund, selling it to avoid a much larger distribution might make sense.
Sometimes it's best to stick with a fund that's about to make a big distribution. If you do so, make sure you don't wind up paying the tax man both now and again when you sell the fund. Financial advisers say that happens when people forget that the shares they receive in a distribution have a different cost basis than their initial purchase. If your fund company isn't keeping track of your cost basis, make sure you do.
Don't despair if you receive a distribution on a money-losing fund. There's a way to recoup your tax dollars. Say you bought $10,000 worth of Fund A last year. Now, it's worth $9,000, and the fund is distributing $2,000 in long-term capital gains. All of a sudden, you owe $400 in taxes on a losing investment. If you sell the fund on the day of the distribution, you can claim a $3,000 loss, which shelters $600 in taxes, says Chris Cordaro, a financial adviser at Bugen Stuart, Korn & Cordaro in Chatham, N.J.
Remember that if you sell a fund at a loss, tax laws prevent you from buying it back for 30 days. So it's a good idea to purchase a similar fund in its place. Of course, make sure you steer clear of funds that are about to make distributions. The last thing you need at that point is a tax bill for some gains you haven't earned yet.