Capital Gains Questions?

November 5, 2007

Mutual fund coverage at The Motely Fool is, to put it mildly, hit or miss - but today they post a nice explanation of what is a confusing issue for many fund investors: capital gains distributions.

When a capital gains distribution is made, the fund's value is adjusted downward accordingly. If you buy just before the distribution, you'll face taxes on an investment you didn't own for very long -- and in many cases, one you never owned. Funds often wait nearly the entire year before paying out gains from a sale early in the year."

The article lists several legitimate techniques you can use to minimize your capital gains exposure, including buying funds with high capital gains potential through non-taxable accounts like your IRA and investing in ETFs (which aren't subject to capital gains distributions).

One note: unlike most fund reporters and analysts (including the author of The Motley Fool's article) we are not big fans of reinvesting dividends in funds held in taxable accounts unless the fees to buy other funds with the distributions are excessive (loads, commissions). It can be very difficult to determine your cost basis later when selling after random reinvest points determined by fund distributions. We prefer putting the cash from various fund distributions into new funds, or to rebalance your current stock / bond / cash stake.