Taxable gain makes a losing year worse And it can happen to a fund investor

Mutual funds

November 01, 1998|By Matthew Lubanko | Matthew Lubanko,HARTFORD COURANT

The 1999 tax season could pack a one-two punch for equity mutual fund shareholders: a paper loss for 1998 and a hefty capital-gains tax bill to be paid in the spring of 1999.

This contradiction -- taxable gains in a losing year -- might seem unfair to holders of equity mutual funds on pace to post a decline in value in 1998.

But contradictions happen.

And several fund companies -- Vanguard Group and John Hancock Funds, to name two -- have written to shareholders, warning that their taxes could climb a little higher as their funds' share prices slip a little lower.

The coming capital gains tax bill could pull a fund's total return even further into negative territory. Heavy stock trading by mutual fund managers, along with a decline in share prices that came late in the fund industry's October-to-October fiscal year, are the main forces that will lead to higher taxes for lower returns, analysts said.

Not since 1990 have so many shareholders had to endure a tax bite on top of a market drop, analysts added.

"One of the negatives of mutual fund ownership is that you have no control over capital-gains distributions. Even if you don't sell any shares, you can still get a big tax bill at the end of the year," said Gerald Perritt, editor of The Mutual Fund Letter in Chicago.

To understand this contradiction -- or injustice -- requires a brief lesson on how mutual funds work. When investors buy shares in a mutual fund, they are providing money for someone to buy and sell stocks and bonds. Stocks and bonds that are sold at a profit -- at prices higher than the purchase price -- generate capital gains. And mutual funds, by law, have to distribute these capital gains to shareholders at least once a year; these gains must also be paid in the same year in which they were earned.

Last year mutual funds paid out $184.1 billion in capital gains distributions, according to the Investment Company Institute, a mutual fund industry trade group.

Yet taxes last year did not seem as painful. The Standard & Poor's 500 stock index rose 33 percent in 1997. With returns so high, the majority who hold taxable mutual fund accounts could say the $30 billion in taxes they paid on their 1997 capital gains distributions was the price for success, said William Saas, a Wallingford, Conn., accountant.

Many other fund owners felt no pain at all during the 1998 tax season that ended, for many, on April 15. About one-third of all equity mutual fund shares are held in tax-deferred individual retirement accounts (IRAs), 401(k) plans, or other employer-sponsored retirement plans. Gains distributed to these accounts will not be taxed until later -- or never.

But the 1999 tax season is likely to be different, Saas said.

And shareholders will have the timing of the stock market's rise and fall, along with the rapid-fire trading practices of many fund managers, to blame for their tax bills in 1999, said Laura Lallos, a senior analyst with Morningstar Inc. in Chicago. Morningstar's newsletter tracks the performance of mutual funds.

"Funds have had three years to build up gains, and not nearly as much time to selectively sell stocks at a loss to offset some of the gains," Lallos said.

When the markets started to decline in July, some fund managers were forced to sell stocks -- and run up more capital gains -- to reimburse shareholders who wanted to move their money to bond funds, money market funds, or bank-sponsored certificates of deposit, Lallos said. Investors pulled $11.2 billion out of equity mutual funds in August, the Investment Company )) Institute noted.

When investors leave a fund, the investors who hold on are left with a larger share of capital gains to divide among themselves, Lallos said. Funds that changed managers during the year are also likely to have run up large capital gains bills. "It's very common for new managers to overhaul the portfolio left by the departed manager," Lallos said.

The average fund also turns over 85 percent of its portfolio in a typical year, according to Morningstar.

"These days, the average share is held for about six months. Higher turnover is meant to improve returns, but it can lead to a higher gains distributions," said John C. Bogle Jr., chief investment officer of Numeric Investments Inc. in Cambridge, Mass.

At the end of all this tumult, fund shareholders could face a tax bill they're not expecting, Lallos said.

Pub Date: 11/01/98

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