Year-end tax planning looms more important

MUTUAL FUNDS

November 21, 1993|By WERNER RENBERG | WERNER RENBERG,1993 By WERNER RENBERG

Year-end tax planning is always important for mutual fund investors. This year, it may be even more important than it has been for at least two reasons:

* New higher federal tax rates for high-income investors.

* The likelihood that your equity and bond funds -- including tax-exempt funds -- will declare taxable distributions of capital gains.

If your marginal federal tax rate remains at 31 percent or has increased to 36 percent or 39.6 percent, you'll want to remember that the tax on long-term capital gains remains capped at 28 percent.

Major fund companies indicate that distributions of capital gains may be larger and more common than those of last year, because many portfolio managers decided to sell securities that had appreciated sufficiently in their eyes to become "fully valued." (The prospect of large long-term distributions led American Funds to send dealers an advisory.)

Managers presumably have continued to base sell/hold decisions on whether securities retain investment merit, not on whether sales would lead to the 15-28 percent brackets or to higher taxes on distributions.

But, nevertheless, they have been made more alert to tax considerations because of the larger spreads between tax rates on short- and long-term capital gains and because deferring sales until gains are long term could trim tax bills for some shareholders.

Increasingly, investment advisers have updated managers on the unrealized short- and long-term gains and losses on their holdings. "It's a new way of life," says Paul Beste, Strong's tax director.

While tax considerations usually shouldn't drive your investment decisions either -- with exceptions, such as choosing tax-exempt funds when appropriate -- you need to remember them to enhance your returns.

Year-end planning for your fund portfolio could involve:

* Timing investments that you may still wish to make in 1993.

* Timing redemptions that you may still wish to make.

* Estimating potential income tax consequences of your 1993 fund redemptions and distributions to determine what, if any, actions may be desirable before the year-end to reduce your 1993 tax bill.

* Starting to update your fund records to ensure that, when you calculate your tax liabilities, you avoid overpaying -- or underpaying.

Investments

Timing year-end investments in an equity or bond fund (outside of tax-deferred accounts) should take into account the likelihood that the fund will declare year-end income and capital gains distributions on which you probably would have to pay taxes. (That is, except for income dividends paid by tax-exempt funds.)

Thus, if you plan to invest before Jan. 1, it should pay to ask the company whose fund you're considering whether either distribution is scheduled. If so, ask for the record date and invest the following day.

When you call, you may be surprised by what you learn. Some funds which have excelled this year, such as Twentieth Century Ultra, won't pay capital gains distributions because they've carried over losses from earlier years. Others, which have been disappointing in 1993 -- such as Twentieth Century Growth -- will declare larger distributions than in 1992 because of realized gains due to portfolio switches.

Redemptions

If you are in the 31 percent or higher bracket, plan to redeem a fund's shares to realize a gain before the year-end, and will have held them for a year or less, it may pay you to find out whether the fund will distribute long-term capital gains.

If management plans to do so but you redeem too soon, all of your capital gain will be regarded as short term and taxed at 31 percent or more. If you wait, your short-term gain will be reduced by the amount of the long-term distribution, on which you will owe federal tax of 28 percent regardless of how long you have held the shares.

Recordkeeping

Nothing seems to frustrate fund investors as much as having to calculate the costs of fund shares, after redeeming them, to determine the capital gains on which tax is owed.

This can be very tricky when you redeem shares that you bought on many occasions -- including regular purchases by dollar cost-averaging.

If you haven't yet done so, this may be a good time to go through past statements to try to compute the costs of the fund shares you own. By having your figures up-to-date, you will be prepared whenever you sell -- and be certain that you reflect the costs of shares bought by reinvesting distributions on which you already have paid taxes.

For descriptions of the four methods that the Internal Revenue Service lets you choose from to figure the costs of shares sold, get a free copy of Publication 564 ("Mutual Fund Distributions") from IRS.

A few firms, such as T. Rowe Price and Vanguard, are helping shareholders by sending them statements that give cost data based on one of the methods.

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