With annual returns as high as 30 percent for many stock mutual funds this year, it's tempting to tally up your profits.
But don't forget to calculate the effect on your profits of Uncle Sam.
Mutual fund investors who have enjoyed the yearlong rally in stocks soon will get the good news-bad news reports from their fund companies that detail the year-end payouts, called distributions, from their funds.
Many investors will see a nice big number, with most rolling their gains into new fund shares.
The bad news is that unless you hold your funds in a tax-deferred retirement account, you owe taxes on that nice big number.
"Last year you were fortunate if you got a distribution," said Colette Coffman, manager at Value Line Mutual Fund Survey, remembering the generally dismal returns for stock funds in 1994.
If you own 100 shares of Fidelity Investment's Magellan fund, you've seen your investment grow almost 40 percent since January, according to Chicago-based Morningstar Inc.
Fidelity estimates that Magellan's 1995 year-end distribution will be $4.80 per share, compared with no distribution in 1994, when the giant fund finished the year with a slight negative return. But this year, for your 100 shares, you'll receive a year-end distribution of $480. On that you'll likely owe about $134 in capital gains taxes, based on a 28 percent rate, if all Magellan's gains came from long-term buying and selling of shares, and not from any dividend payments on the stocks it holds. (Year-end distributions include income from dividends on stocks that a fund holds as well as any realized capital gains.)
Not all mutual funds are alike, however, in their impact on their shareholders' taxes.
Many funds at Vanguard Group of Investment Cos. utilize a "tax-efficient" strategy, which reduces or sometimes eliminates capital-gains tax burdens while still allowing decent gains.
The Vanguard Index Trust 500 portfolio, which buys and holds the stocks of the S&P 500 index, reaped 29.2 percent for investors through Oct. 30, a spokesman said. Based on taxable gains realized through Oct. 30, however, its distribution would be only 18 cents a share, the company said.
If those gains remain stable, a 100-share investment in the Vanguard portfolio is likely to generate a tax bill of about $5 this year, based on a 28 percent capital-gains rate.
Obviously the gains must be recorded somewhere: In this case, the Vanguard fund built up an estimated $12.88 per share in unrealized gains through Oct. 30, the company said, for which long-term shareholders eventually will have to pay taxes.
These examples illustrate a point about the management of mutual funds. Annual distributions from a fund depend heavily on how much of a fund's gains a fund manager has realized -- or cashed in -- during the year. Generally, the more trading a fund manager does, the higher the annual taxable distribution.
One Fidelity fund, the Trend Fund, has offered shareholders an almost 23 percent return as of Dec. 5 -- substantially underperforming the S&P 500 index -- but expects a sizable distribution of $10 per share for 1995, according to Fidelity.
Kemper Financial Services Inc.'s Kemper Growth Fund, in contrast, brought investors a more than 30 percent return through the same date but expects to make a relatively modest distribution of $1.63 to $1.70 a share this year, according to a spokesman.
By law, funds must distribute gains to shareholders if the fund has actually cashed in shares that have risen in value during the year, unless they're offset by a loss on other shares.
Three funds at Vanguard use an active "tax-management" strategy to try to offset any realized gains with losses and keep shareholders' tax burdens at an ideal zero, Vanguard said.
Vanguard's Tax Managed Growth & Income portfolio, which mirrors the S&P 500 index, had the same 29.2 percent return as the Vanguard Index Trust 500 fund as of Oct. 30, a spokesman said. But the tax-managed fund has estimated realized gains -- dTC which would be taxable -- of zero through Oct. 30, Vanguard said.
Capital-gains taxes most often come into play with stock funds, especially growth-oriented funds, which favor stocks with rapidly increasing value but little or no dividend payments.
Shareholders must pay ordinary income taxes -- at whatever rate their bracket dictates -- on gains from dividends and gains from shares that the fund held less than a year.
Morningstar and Value Line offer an analysis of funds' tax efficiency in their reports.
Many advisers caution investors looking to buy new shares at this time of year.
"You don't want to buy just prior to the distribution date, because you end up paying taxes on a gain that's not yours," said Value Line's Ms. Coffman.
That's because when distributions are being made at the end of the year, all fund shareholders get the same amount, even if they bought in just a week before.
Because fund shares are repriced lower by the amount of the distribution when it's made, new shareholders aren't actually losing money on their new investments, Value Line noted in a report. But they lose the advantage of deferring the taxes.
