Ask MAX: Capital Gains Quickies

April 24, 2006

Dear MAX,

I'm a mutual fund investor who was hit with taxes on my fund holdings this year (after a few years without paying any). Frankly, I'm not entirely clear on what a capital gains distribution is. I asked my accountant and he didn't seem to be able to explain it to me. Can you help?

Minneapolis, MN

Dear Andrew,

In most cases, mutual fund investors haven't had to worry about their fund’s tax bills since 2000. Weak market returns from 2000-2002 meant that there weren't any capital gains to distribute in the early part of the decade, and the losses many funds realized offset some of the gains made in the following years. But strong performance of many funds from 2003 to 2005 has finally caught up with fund investors, creating a rough tax burden for many of them this year. In 2005 Lipper estimates fund investors paid a whopping 58% more in taxes on fund distributions than in 2004.

We love mutual funds. Mutual funds provide cheap and easy investment diversification, they're easy to get in and out of, they're highly regulated, and they allow investors access to expert financial guidance at a low price. As investments go, we think that mutual funds are far and away the best available for the vast majority of investors in America.

But there are a couple of things about mutual funds that we don't like: Fund investors never know exactly what they're invested in, some mutual funds charge excessive fees, and worst of all, mutual funds sometimes hit investors with large and unexpected taxable distributions.

Capital gains are an unavoidable mutual fund evil. Capital gains distributions occur when a fund makes a profit on its purchases and sales of securities. Like in your own portfolio, if a fund sells a stock at a higher price than it paid, it realizes a capital gain. If it sells securities at a lower price, it realizes a capital loss. If the gains are greater than the losses over a given period, the fund has 'net realized capital gains', which by law have to be distributed to fund shareholders each year.

Most fund companies announce their fund's capital gains distributions in late winter, and when the distribution is actually made the NAV (net asset value, or price of each fund share) of the fund drops by the amount of the total distribution (long and short-term capital gains, as well as dividends accumulated by the fund from stocks). Shareholders of the fund are either mailed a check for the amount of the gain, or are given the amount of the gain in new fund shares. If investors are automatically reinvesting, as most do, the value of their investment will be the same before and after a distribution – but they’ll own more shares at a lower price.

What stinks about capital gains is that while the value of each shareholder's investment doesn't change one bit after a distribution is made, investors still have to pay taxes on the amount of the distribution.

In 2000 Warburg Pincus issued a whopping 55% capital gain distribution to shareholders of their now defunct Japan Small Company Fund. This means that if you were unfortunate enough to own shares of that fund, you had to pay tax on the equivalent of 55% of your investment. The fund, by the way, was down 71% that year.

Unfortunately, there is no foolproof way to avoid getting hit with a fund-related tax bill. Some funds make big distributions year after year. Other funds rarely if ever do. It's very difficult to predict with any certainty how large a fund's distribution will be before the fund company announces it.

Funds with big turnover ratios tend to make larger-cap gain distributions than funds with low turnover ratios, because turnover ratios measure the amount of trading a fund manager engages in. If the manager doesn't trade much (and hence, has a low turnover ratio) there is less chance to run up significant capital gains. Worse, funds with high turnover are generally realizing short-term taxable gains (gains on stocks sold within a year of purchase), which are taxed as income (high rate) and not as long-term capital gains (low rate). Fund managers could care less – they are ranked on pretax returns.

The best way to lessen the capital gains bite is to own your mutual funds through a tax-deferred account like an IRA or a 401(k). If that's not an option and the idea of looming tax bills keeps you up at night, you might consider so-called tax-managed funds – mutual funds whose managers take active steps to reduce the possibility of generating taxable gains for their shareholders. Vanguard Tax-Managed Balanced Fund (VTMFX) is a good low-cost pick in the tax-managed category.

Call your funds toward the end of the year and check their websites for distribution dates and estimated distribution amounts. Links to fund websites and phone numbers are available from fund pages on the site.

Do not buy a fund that is about to make a large distribution, particularly if that distribution is going to be largely short-term capital gains. Consider selling a fund that you may want to sell soon anyway if it is going to pay a large capital gains distribution. This is especially true if you have a loss you can realize on the sale, or a long-term capital gain (low tax). Often there is a similar fund you can buy, or you can simply wait until the IRS’s so-called wash sale time period (60 days) elapses and buy back the same fund.

Consider ETFs when there is not a compelling mutual fund choice available. ETFs are not as tax-inefficient as ordinary mutual funds; they are almost always low turnover, and they generally don’t build up taxable gains that require sudden large distributions to the unfortunate investors who own the fund on a certain date.

Consider funds that have recently – particularly if they once had a large asset base. While this seems like a bad idea on the surface (who wants a loser?), funds that have fallen on hard times generally have tax loss carry-forwards on the books that will wipe out any realized gains for years to come. Such funds often perform well as they have contrarian appeal. This is by no means a recommendation to buy long-term losers, or funds that are not merely suffering from a strategy that is temporarily out of favor.

Thanks for the question.


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