Easing taxes on mutual fund gain


December 18, 2007|By EILEEN AMBROSE

Mutual fund investors brace yourselves: You might be in your biggest tax bite since 2000.

Around this time each year, funds pass on dividends and capital gains earned on the sale of securities to investors. This year's distributions are expected to be exceptionally high, partly due to the volatile stock market.

"This will be one of the worst [years] we have seen on record in terms of the tax bill," says Tom Roseen, senior research analyst with Lipper Inc.

Roseen estimates that this year's tax tab will be close to that of 2000, when fund investors in taxable accounts paid $33.1 billion in taxes on capital gains and dividends. That's a record in the dozen years that Lipper has tracked these figures.

And if Roseen's right, that would be a substantial bump up from last year, when fund investors surrendered $23.8 billion to Uncle Sam.

There are ways for you to minimize the tax bite. Some can't be much help with 2007's tax bill, although they can reduce future taxes. Still, as much you might hate taxes, capital gains aren't necessarily bad. Far better to have a high-performing fund that throws off gains than a mediocre fund that languishes from year to year or even loses money.

"There's nothing worse than paying taxes than not paying taxes," Roseen says.

Fund companies usually warn investors a month or two before the capital gains distribution about what to expect, giving them time for tax planning.

Baltimore's T. Rowe Price Associates, for example, says the average capital gains distribution for stock funds this year is $1.77 a share, up from $1.05 a year ago.

At Muhlenkamp & Co., the capital distribution will be $12 a share. The Pittsburgh fund hasn't made a capital gains distribution since 2000.

Portfolio manager Ron Muhlenkamp says he jettisoned some stocks earlier this year that had run their course, including housing, financial and consumer cyclical stocks. Among them was Merrill Lynch, which Muhlenkamp sold for a profit of $45 per share.

Taking profits isn't the only reason for larger distributions. Blame stock market volatility, too.

"It's been a roller-coaster ride," Roseen says. Queasy investors pulled out of funds in search of more stable investments. When they redeem shares, the funds end up selling securities and pass any gains on to the rest of investors.

Distributions are up, too, because many funds no longer have losses to write off. Funds can uses losses to offset gains on tax returns. If losses exceed gains - which happened in the last bear market - those losses can be carried forward to offset future gains. The impact of gains in recent years has been lessened by past losses. Now those losses have been used up.

Even with distributions rising, investors can take solace in the fact that long-term capital gains and qualified dividends are taxed at a low rate of 15 percent. "That's about as good as it gets," Muhlenkamp says.

Still unhappy? There are a few strategies to limit taxes. Again, some are designed to limit future tax bills, not this year's tab.

Don't jump into a fund that's about to make a large distribution.

Weed out losers in your portfolio that you no longer want and use those losses to offset your capital gains.

Invest in tax-managed funds. Or consider index funds, which don't often change their holdings or throw off a lot of capital gains.

Consider exchange-traded funds. They are similar to index funds but can be more tax-efficient. You generally pay taxes when you redeem your ETF for a profit - not when other investors sell shares - so you have more control over your tax situation.

If you like a fund that throws off a lot of capital gains, hold it through a tax-deferred individual retirement account rather than a taxable account, Roseen suggests. You'll eventually pay taxes on the money at an ordinary income tax rate when you make withdrawals, but by that time you might be in a lower-income tax bracket.

If none of these solutions work for you, just count yourself lucky that big distributions are happening now and not 2011. That's when the 15 percent tax rate on gains and dividends is set to expire.

Questions? Comments? Want to share your own financial tips with readers? Contact Eileen Ambrose at 410-332-6984 or by e-mail at eileen.ambrose@balt sun.com.

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