Mutual-fund investors are in for an unpleasant surprise later this month: they may owe even more taxes than they did last year.
Last year, the industry's year-end distributions of dividends and capital gains hit an all-time high of $418.5 million. That was 10% more than the previous record of $376.7 million in 2000. Despite, or perhaps because of, the stock market's volatile performance this year, tax bills for 2007 look to be heading even higher.
The average U.S. stock fund is up 6.29% for the year through Nov. 29. While that's not exactly shooting the lights out, many have sold securities they purchased at even lower prices in previous years, realizing big capital gains.
Tom Roseen, senior research analyst at fund research house Lipper, says the tax picture for fund holders hasn't looked this bad since the tech bubble burst.
"In 2000 we had some of the worst returns in ages and the largest tax bill on record. It was a double whammy. This year has the potential to be a similar situation."
That's the picture at
T. Rowe Price Group
; Sam Beardsley, director of investment taxation at the Baltimore firm, says capital gain distributions will rise significantly this year. As of Oct. 31, the firm's retail equity funds expect to see an average capital gain distribution jumping to $1.77 a share from $1.05 in 2006, a 68% increase. However, he doesn't expect to see significant increases in distributions by bond and income funds.
Beardsley points out that the percentage of the fund's net asset value that is paid out in distributions is an even more important measure. On average at T. Rowe Price, it's gone up to 5.96% this year from 3.71% in 2006, a 53% increase.
By comparison, the largest payout of any T.Rowe Price fund in 2000 was 6.14% of NAV.
However, Beardsley adds, emerging European funds may see a 10% payout this year.
Mutual funds make money from both income -- the interest and dividends paid by its underlying securities -- and capital gains realized when it sells the securities at a profit.
While some funds sell shares to take a profit, many only sell shares to raise cash when investors want to redeem shares. (The typical mutual fund doesn't keep much of its assets in cash.)
This income is then passed through to the fund's shareholders. While shareholders put the money back to work by buying new shares, they are still liable for paying taxes on this income.
Conversely, when funds sell their holdings for less than they paid, they record a capital loss.
In recent years, mutual funds have been able to offset some of the capital gains they realized by carrying forward tax losses incurred during the tech bubble. But by 2006, most of these tax-loss carry forwards had been used up.
This year, 82% of all taxable funds are expected to pay taxable gains, compared with 75% last year, says Beardsley.
Funds need to close their books by Oct. 31, then start calculating capital gains. They are required to pass 98% of the distributions to shareholders by Dec. 31. Then, once the distribution is made, the fund's share price drops by that amount.
Most shareholders reinvest the proceeds, buying more fund shares. Still, they have to pay taxes on capital gains distributions no matter how long they have been invested. That's why it's always a dicey proposition to purchase or add to your fund holdings in the fourth quarter of the year. (For tips on how to avoid purchasing funds with big tax bills, click
When funds make capital gains distributions, investors get to mark up their costs basis accordingly; so they pay less in tax when they eventually sell their shares. Still, it's annoying to get hit with a tax bill so soon after making an investment.
The bills are bigger at some of the giants of the fund industry. "It's hard to broadly characterize, but it looks like more funds will be distributing larger gains than last year," says Sophie Launay, a spokeswoman for Fidelity Investments. Fidelity's
Website lists 151 funds that are expecting to make a distribution this year.
Vanguard Group says the picture is mixed. Some funds, like
Strategic Equity (VSEQX), are paying a bit more: its capital gains distribution for 2007 is 9% of NAV, up from 4% last year.
Others are paying less: The
Vanguard Explorer Fund's (VEXPX) 2007 distribution was 8% of NAV, down from 10% in 2006.
"Across the board, capital gains (payouts as a percentage of NAV) aren't much different this year compared to last," says Vanguard spokeswoman Amy Chain. "And a healthy number of funds -- and not just tech funds -- still have some tax losses to carry forward."
In fact, every Vanguard fund that had a tax loss carry forward in 2006 has one for 2007 as well, she says.