Buying a fund now just might prove tax foolish

Your Funds

November 21, 1999|By Charles Jaffe

HIT THE brakes, check tax traffic before buying funds at year's end.

Most investors think of "tax time" as the winter and spring months when they prepare their tax returns.

For mutual funds, however, tax time is right now, which is why investors looking to put new money into the market need to be careful now, in order to avoid a tax headache next spring.

In the next few weeks, most funds will make their annual distributions of dividends and capital gains. Shareholders with taxable accounts will owe Uncle Sam for those gains.

The gains are already in the funds, reflected in higher share prices and waiting to be distributed, so you can't sell now and beat the tax man. What you can do, however, is delay purchases until you learn whether buying a fund before its gains payout will create an instant tax bill.

Here's how and why:

Mutual funds are a "pass-through entity," meaning that the tax liabilities pass through the fund and to the shareholder. By law, funds must pay shareholders at least 98 percent of the dividends and capital gains (profits made when investments are sold) realized each year.

If a fund trades at $10 per share and 10 percent of its value represents the capital gains it has accrued this year, it will pay $1 per share to investors. (The fund's share price will drop by that $1 when the gain is paid.)

Based on current federal capital gains tax rates, at least 20 cents of every one of those dollars is going to the tax man, even if you reinvest gains and never touch the money. (Your fund's short-term gains are taxed at your ordinary income tax rate, with long-term gains pegged at a 20 percent rate. On a fund with high turnover and a lot of short-term gains, you could lose nearly 40 cents per dollar to federal taxes.)

Buy the fund just one day before gains are distributed and you have the same burden as an investor who was in for the whole year, although you didn't benefit from the gains.

In short, you owe taxes for gains you never received.

Let's use that $10 fund with the 10 percent capital gain and see how it works if you invest $5,000 now.

You get 500 shares today. Come, say, Dec. 5 when gains are distributed, however, you get $500 of that new money back. Since the share price falls by the amount of the $1 gain, your 500 new shares are worth $4,500.

You can reinvest the $500 gain to keep $5,000 in the fund, but the $500 "profit" is reported to the IRS.

Waiting until after gains are paid lets you sidestep the tax bill.

The obvious exceptions to the wait-until-gains-are-paid strategy are any funds in tax-sheltered accounts and retirement plans -- for which no taxes are due until the money is withdrawn -- and bond funds that regularly pay income and dividends and don't allow for a yearlong buildup. In addition, there is little reason to put off buying funds that are tax-efficient and have few gains to distribute, such as index funds.

Most experts recommend that investors do not disrupt automatic investment plans, in which small amounts go into the fund each month. The minimal tax savings on a small monthly purchase is not worth breaking the discipline of regular investing.

The key to end-of-year purchase timing is the fund itself. Even funds that post losses or minimal growth can have enormous capital gains to distribute.

In an effort to lock in gains, beat back a decline or reshape a portfolio, a manager might sell or trade stocks. The fund could be losing ground, yet the manager who unloads long-term winners will generate a tax bill for shareholders (unless those gains can be offset by the fund selling its losers, too).

The fact that the problem exists does not mean investors should put off investing until the end of the year. It is just a warning to proceed with caution.

Many fund families make preliminary gains estimates, saying when they plan to pay gains and how much they expect to distribute. Those estimates should be available by now, either on a fund firm's Web site or by calling its service center.

Estimates are fluid and have been wrong, but they allow for a ballpark estimate of the "tax load" you pay if you invest before gains are distributed. Divide the projected gain by the current share price. Multiply the result by the amount you plan to invest and the result is the amount of money the fund would return to you when it pays gains. Expect one-fifth to one-third of that money to be added to what you owe the government on your next tax return.

From there, the decision becomes easy. If the tax burden is big enough that you would want to avoid it, delay investing until after the distribution date. Otherwise, you can invest now with a sense that your new fund won't be part of your tax headaches next year.

Charles A. Jaffe is mutual funds columnist at the Boston Globe. He can be reached by e-mail at jaffe@globe.com or at the Boston Globe, Box 2378, Boston, MA 02107-2378.

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