Are You Ready for Some Tax Hits? Fall's the Season for Fund Distributions

Ah, fall. That special time of year when one's thoughts turn to long walks along leaf-covered paths, endless hours of NFL coverage, gathering the family for Thanksgiving and, of course, capital-gains distributions.

OK, maybe capital-gains distributions aren't at the forefront of your mind right now, but they should be. Most mutual fund companies distribute their capital gains to shareholders in December, so many of them will begin releasing their preliminary distribution estimates this month. While these estimates are by no means final, investors should check them out to prepare themselves for what kind of tax hit they might be in for come filing time.

Capital-gains distributions occur when a mutual fund sells a holding in a stock, creating a taxable gain (or a loss) that is then passed on to the fund's shareholders.

A preliminary view of the most recent estimates from top mutual fund companies shows many funds already preparing to distribute 10% of their net asset value (NAV, a fund's share price) or more in capital gains. Generally, distributions of 10% or higher are considered large.

Some funds already are well above that limit. As of the end of September, the $685 million (FJSCX)Fidelity Japan Smaller Companies fund was on track to distribute a whopping 28.3% of its NAV, while the $1.5 billion (FSCSX)Fidelity Select Software and Computer Services was not far behind with a 27.5% estimated distribution. In August, the $240 million (WPJPX)Warburg Pincus Japan Small Company fund and the $226 million (WPJGX)Warburg Pincus Japan Growth fund announced distributions of around 55% and 22%, respectively.

The $1.9 billion (JAVTX)Janus Venture fund is a prime example of a fund that is not only dramatically underperforming this year but is also on track to yield a hefty capital-gains distribution. Down 29.6% year to date, at the end of September the fund was estimated to yield an $18.45 capital gain, or 22% of the fund's NAV.

Those heavy estimates have many market watchers bracing themselves for more mammoth capital-gains distributions this year. And with the average technology fund gaining a whopping 135% return last year, chances are that many of 1999's skyrocketing funds have taken some profits on their more highflying stocks, leading to large capital gains for this year.

"Last year and the year before there were fairly unusual high capital gains," says James Lund, senior financial adviser and certified financial planner with American Express Financial Advisors. "We're probably looking at a repeat of last year's unusually high levels."

Though that may be true, this fall's tech selloff might change the picture somewhat for capital-gains distributions, says Morningstar's director of fund analysis, Russ Kinnel. That's because many of the tech-heavy funds that did so well in 1999 and in the first quarter of this year experienced some steep losses. So even if these funds did take some profits earlier this year, those gains would be offset by the sharp losses seen this fall.

"If you asked me a few months ago, I would have said all of those funds that had big gains last year are going to have big distributions," says Kinnel. "Some may, but others won't."

Signs that your fund may make a large distribution include a change in portfolio manager or strategy, which could signal that a fund is about to sell some of its holdings to make way for new investments, says Kinnel. Investors also might want to watch out for a fund that has seen a lot of outflows, because that means the fund's management could have to sell holdings to meet the mounting redemptions.

So what to do if your fund is in for a big distribution? That depends on how well the fund is performing. Dave Yeske, a certified financial planner with Yeske & Co. in San Francisco, says a fund that will distribute large capital gains but is also not performing well could be a candidate for tax selling. That is, sell the losing fund to generate a tax loss and then turn around and buy a similar fund to keep the same asset allocation in your portfolio.

"More and more these days you can find funds that are essentially identical, and your portfolio's profile has not changed at all," says Yeske.

If the fund is performing well and you plan to stay put for a while, planners say you might just have to suck it up and pay the capital-gains tax. After all, you are in a mutual fund to make money. But if paying capital-gains taxes is an issue, you may want to check out funds with low turnover such as index funds, which generally post very little, if any, capital-gains distributions.

"If there's a capital-gains distribution of more than 7% to 10%, and if you've owned the fund for a long time and you fully benefited from the gains represented, that's not too bad," says Yeske.

(For more information about capital-gains distributions, please see the following article.

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