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Mutually Surprising Tax Hits

Jennifer Openshaw

It's capital gains season again for those of you who hold -- or are planning to buy -- mutual funds in taxable accounts.

And depending on what fund you're talking about, this year may hold more tax surprises than most recent years. Why? I'll get to that in a minute.

First, let me refresh you on how capital gains distributions work. Most funds, especially the actively managed variety, buy and sell stock and other securities throughout the year. As the security portfolio gains value through the year, so does the so-called "Net Asset Value," or NAV, of the fund. So your shares increase in value through the year.

As required by investment company law, funds must distribute capital gains exceeding recognized capital losses each year.

So sometime during the fourth quarter, the fund manager tallies gains in excess of recognized losses for the year and declares a capital gain and distribution date. Most of these distributions occur in December.

There's nothing new about this procedure. But what is new: For the first time in several years, many funds have sizeable gains to distribute.

Why? One simple answer: strong markets. But more than that, mutual funds are allowed to carry forward net capital losses to offset gains for eight years. Many funds incurred losses as the bull market unwound in 2000 through 2002. But now those losses have been exhausted, bringing better gains than ever at least for some funds.

So just for example, in the Fidelity fund family, the widely-held Contrafund plans a long-term capital gain distribution of some $5.27 per share. Many of their "Select" funds also plan large distributions, topping out with the Fidelity Select Leisure Fund at $8.57 per share. You get the idea.

Now, remember that a gain is better than a loss, and especially with top federal capital gains tax rates capped at 15%, taxes may be reasonable. But you should do your homework and plan accordingly. Most funds have a tax information Web page (link to Fidelity's here) or you can call the fund manager directly

It's probably too late to do much for the 2006 tax year, but here are some suggestions.

Short term:

• Don't buy any fund at year-end without checking tax status. If you buy before the gain is distributed, the price you pay will include the gain, and you'll pay taxes on the distribution. Effectively, you pay tax on someone else's gain. Check the distribution date with the fund (or call your broker) and buy afterwards.
• Look for losses in your portfolio. If you're alarmed about a declared gain, find another offsetting loss and take it before year-end.

• Select "tax efficient" funds -- as declared in their charter or evidenced by low portfolio turnover. Tax-efficient funds manage so as to minimize your tax impact. See the prospectus or talk to the fund advisor. Check the percentage turnover rate. If it's more than 20% to 30%, you're susceptible to more taxes in a taxable account.
• Avoid actively managed funds in taxable accounts. Look into Exchange Traded Funds (ETFs) or index funds; these funds buy and sell securities usually only when index components change, minimizing tax exposure.

Remember, while today's capital gains taxes are moderate, even a small "take" from your portfolio every year can derail the compounding train. A sum of $10,000 invested for 20 years grows to $32,000 at 6% annually but only $18,000 at 5% -- so the tax bite is worth avoiding.

Warren Buffett is famous for never selling anything -- and maybe your mutual fund shouldn't either. But if it does, be aware of the consequences.