Ho, ho, big payouts oh-oh, big tax bite

Mutual funds

Coming distributions a Christmas boon, but beware of capital gains

November 26, 1995|By BLOOMBERG BUSINESS NEWS

It's shaping up to be quite a merry Christmas for mutual fund investors, distribution-wise. Some of the biggest funds will be making their biggest payouts in years.

And that's both good news and bad news for investors.

The estimates from two of the nation's biggest stock mutual funds provide an early indication of the magnitude of this year's distributions -- the most direct and dramatic evidence of just how good this year has been to investors. That's the good news.

The bad news is the potential tax consequences.

Fidelity Investments' Magellan Fund estimates it will pay out 5.4 percent of its current net asset value in a year-end distribution. Vanguard Group's Windsor Fund expects to pay out about 9 percent.

A year-end fund distribution of 5 percent is above average from a historical perspective, said Brad Szczecinski, an analyst at Perritt Capital Management Inc. in Chicago.

"But, it's been a very good year for mutual funds, so it's not a surprise that fund distributions are bigger than normal," he said.

The average stock fund is up 27.7 percent this year, recording the biggest returns since 1991, when the average stock fund was up 36.3 percent, according to Lipper Analytical Services Inc., which tracks mutual fund returns.

Fidelity estimates that holders of the $53 billion Magellan Fund, the world's biggest mutual fund, will receive $4.80 a share in capital gains and income distribution on Dec. 18.

Vanguard estimates that holders of its $13.4 billion Windsor Fund will get $1.39 a share in a capital gains distribution on Dec. 18. Vanguard hasn't yet disclosed what the Windsor fund's income distribution may be.

But the one piece of coal in the bottom of an otherwise stuffed Christmas stocking goes to investors whose holdings of the Magellan and Windsor funds aren't sheltered from federal taxes.

They'll be responsible for paying a 28 percent tax on the capital gains portion of the distributions, even if the distributions are reinvested in the fund. The income portions are subject to ordinary income tax rates -- which vary according to income and can be as high 39.6 percent.

Fidelity didn't specify how much of the Magellan Fund's distribution will be subject to the capital gains tax rate and how much will be subject to the ordinary income tax rate.

People who hold shares of the Magellan and Windsor funds in a 401(k) or in any other tax-advantaged retirement account are exempt from making the payment.

There's still a way for investors who aren't holding shares in tax-advantaged accounts to avoid a big tax hit:

Cash in shares of the fund before the distributions are paid. Then, if you still like the funds, buy them back afterward.

But first, compare the difference between the capital gains you'd have to pay on the distribution against the gains you've made on the shares during the time you held them.

Take the course that leads to the lower tax.

When a mutual fund makes a distribution, it's not like Mobil Corp. raising its dividend. An investor with $10,000 in the Magellan fund who receives a distribution and reinvests it will still have $10,000, assuming the market doesn't move.

The distribution does create a long- or short-term capital gain. If it's in a taxable account, you'll have a liability to Uncle Sam regardless of whether you're losing or making money in the fund.

To avoid paying an excise tax, mutual funds must distribute to shareholders by Dec. 31 an amount equal to 98 percent of their ordinary income for the calendar year and 98 percent of their capital gains for the 12-month period that ends Oct. 31. If a fund doesn't pay out all the distributions, it's subject to a 4 percent excise tax.

If there is no income or capital gains, there is no distribution requirement.

The Fidelity fund that's expected to pay the highest distribution is the $1.28 billion Trend Fund. Fidelity estimates the fund will distribute $10 a share, or 16.1 percent of its current net asset value, in capital gains and income.

That fund was restructured this year by its new manager, Fergus Shiel, who took control of it in May, said Scott Beyerl, Fidelity's spokesman.

Mr. Shiel restructured the Trend Fund to match his investment style and "that led to significant realized capital gains from holdings that were sold," Mr. Beyerl said.

Mutual funds specializing in technology stock investments are generally expected to pay the biggest distributions, because they've rallied so strongly this year.

Baltimore-based T. Rowe Price Associates Inc. estimates that its $2 billion Science & Technology Fund will pay out $3.93 a share, or 12.3 percent of its current net asset value, in a year-end distribution.

Last year, the fund paid out a distribution of only 30 cents a share.

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