Don't go crazy trying to beat Uncle Sam out of a few bucks

Your Funds

Your Money

November 28, 2006|By Charles Jaffe | Charles Jaffe,Marketwatch

December typically brings cold weather, warm greetings and some of the least-worthwhile "common-sense" mutual fund advice known to investors.

This year looks to be no exception, as the early estimates show that 2006 will test investors' knowledge of how capital gains taxes are applied to mutual funds and how they should react.

The rule of thumb in question starts out well enough, but goes wrong in the execution. It goes something like this: Never buy a fund in December if it is making a big capital gains payout.

The problem is not so much the strategy as it is the use of the word "never."

To see how and why the strategy comes into play - and sometimes goes awry - we must first delve into the way fund distributions are taxed.

Mutual funds are "pass-through entities," meaning that tax liabilities incurred while trading securities pass through the fund and on to shareholders. By law, funds must distribute at least 98 percent of the dividends and capital gains - profits made when investments are sold - realized each year.

Most fund companies estimate those distributions, typically putting a forecast on their Web sites in mid- to late November.

If you hold a fund in a tax-advantaged account, current distributions are not your problem. You'll settle up with Uncle Sam, eventually, when the money is withdrawn from the account.

But if you hold funds in taxable accounts, Uncle Sam will want his share of your distributions next April, even if you reinvest the payout and never touch the cash.

A fund may be finishing a flat or losing year, but still make a payout because management closed out positions on previous winners. (When distributions are made in late December - and the fund's share price declines by the amount of the per-share payout - I frequently get notes from confused investors, wondering what happened to their fund; typically, they have a tough time believing that there can be oversized gains on a fund that has been mediocre for 12 months.)

Through the early part of this decade, investors seldom had to worry about big distributions. Bear market losses in many funds were sufficient to offset gains for years; those loss-carry-forwards mostly were exhausted a year or two ago.

Some managers keep an eye on tax liabilities as part of their investment style, others don't. And just as past performance is no guarantee of future results, past tax efficiency is not a guarantee that a manager will not have made trades that shake down big gains after years of little or no payout.

That's why it's important to check the payout estimates. You don't want to get caught unaware and end up with a surprise tax bill. (If you can't find estimates for your funds on the Web, call your fund companies to see if they can give you the data directly.)

That brings us around to whether investors checking for gains should change their year-end buying habits.

Invest in a mutual fund even one day before the distribution is made and you owe taxes on the payout as if you had held the fund for the entire year. Wait until the gains are paid and you sidestep the current tax burden. (There is no advantage to dumping a fund before the payout; the gains are built in to the share price, so they automatically factor into your profit on the fund.)

On the surface, that makes the rule-of-thumb on timing December purchases a good one. But holding off December buying only makes sense if the dollars are significant.

If you invest $100 a month automatically, stopping the electronic deposit is not only a hassle, but it won't generate much tax savings. If the fund makes a 25 percent distribution - which is large under any circumstances - you'd be looking at $25 in extra capital gains that might have been postponed by changing the timing of your purchase.

Assuming you are like most investors and facing a 15 percent tax rate on capital gains, your additional burden amounts to $3.75. Even if you invest $1,000, the tax savings still doesn't come to 40 bucks.

What's more, if you pay the additional taxes now - and adjust your cost-basis on the shares accordingly - it reduces the tax burden when you sell the fund, so it's not like the $3.75 is gone forever. And if the fund takes off while you're on the sidelines, that gain is gone forever.

As a result, making yourself crazy - and altering your standard investment practices - trying to beat Uncle Sam out of a few bucks next April is foolhardy. Investigate the potential payout and prepare for what you owe, but don't mess up a calm, knowledgeable strategy unless the dollars you have to invest at this time of the year are big.

Charles Jaffe, a senior columnist for MarketWatch, also can be reached at Box 70, Cohasset, MA 02025-0070.

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