Don't let a capital gains payout get you down

Dollars & Sense

Standard fund advice dispensed at this time every year is either sage or stupid.

The hard part is figuring out which it is, and the answer depends entirely on you and the funds you own.

Every year, many fund experts caution against buying mutual funds now, before year-end capital gains distributions.

The reasoning is simple: Funds will soon pass through to shareholders the profits they realized on stocks sold during the year. When that distribution is made - and most funds make it in December - shareholders owe taxes on the payout, even if they simply reinvest the money and never touch the cash.

So if you buy a fund now and it pays out a huge gain in December, your tax bill goes up.

Wait until gains are doled out, and you can buy the same fund, minus the current tax liability.

That's standard advice for people with taxable accounts. (Tax-deferred investors - people in 401(k) plans, individual retirement accounts and the like - shouldn't sweat current gains.)

This advice is likely to get a lot of play this year. Already in 2000, there have been some huge distributions - such as the 55 percent- of-net-asset-value whopper uncorked by Warburg Pincus Japan Small Company in August - and rumors abound of more to come.

Fund firms are addressing the issue earlier than ever, too.

Vanguard Group and Capital Research & Management are among a few fund families to make estimated-gain forecasts in September.

In mid-October, Fidelity Investments for the first time ever will provide interim capital gains data, based on what funds have accrued through Sept. 30. (A month later, the company will issue its traditional gains estimate on its 50 largest funds.)

Several other fund firms have promised early release of gains data this year, which is a big reason why some industry watchers expect this capital gains season to be particularly painful.

That many funds have had mediocre years compared with recent history is likely to make for some gruesome backlash from angry investors. Warburg Pincus Japan Small Company, for example, was down almost 50 percent for the year when it made the big payout.

Investors can't avoid gains on the funds they already own in taxable accounts, but they can duck-and-cover from gains bombs affecting new investments.

That's where it becomes a judgment call on the standard put-off-your-purchases advice.

To show why, let's examine the hypothetical cases of Jack and Mike. Each has $10,000 to invest.

Jack decides to wait, putting the cash into a tax-free money-market fund for the last two months of the year. The dividends on Jack's money are likely to amount to about $75, giving him $10,075 to invest once gains-distribution season ends.

Mike, by comparison, invests now, and happens to buy something that gets hot. In the last two months of the year, Mike's fund goes up 10 percent, but it also pays out a 20 percent capital gains distribution.

That means the investment grew to $11,000, paid out $2,200 in gains - which we'll assume was reinvested in the fund - and that Mike's tax bill on the distribution (assuming long-term gains taxed at the 20 percent federal rate) amounts to $440. Subtract that $440 in taxes from Mike's $11,000 account value, and he's left with $10,560 at the end of capital gains season.

Before assuming that the Mikes of the world - guys who pull the trigger now - always beat the tax-wary Jacks, realize that the numbers could have been very different had we plugged in other results (and applicable state taxes). Mike could have wound up with a loss in the fund, but still had a tax bill due.

That said, however, don't forget that the Nasdaq composite index was up about 50 percent in the fourth quarter of last year, so Mike's quick gains were not outrageous.

That's why the standard forestall-buying-until-gains-are-paid advice can go either way, savvy or stupid.

It's stupid for an average investor making modest investments - or for the person making small-but-regular deposits - to interrupt their investment program in order to save a buck or two (and not much more) on the tax bill. For people with bigger money to invest, the quality of the advice depends on the fund's performance potential vs. the size of the gains payout.

If the fund rises dramatically in the next two months, you not only miss out on the increase, but you also have to pay more to buy the fund later on. If the fund plods along but pays out a big gain, you face the tax penalty.

Ultimately, the decision is yours. Ask fund companies (or check their Web sites) for gains estimates. Use those numbers to calculate the potential tax exposure; determine how much the fund would have to grow by year-end to recoup the taxes.

Only then can you decide if the old saw about year-end purchases is right for you and the funds you have your eye on.

Chuck Jaffe is mutual funds columnist at the Boston Globe. He can be reached by e-mail at [e-mail] or at the Boston Globe, Box 2378, Boston, Mass. 02107-2378.