(BTTTX) - Get Report American Century Benham Target Maturities Trust 2020 is a major financial irritant to me. I have been in the fund since October, and on Dec. 11 it declared a $7-plus capital-gains distribution. This is over 20% on a fund with an approximate price of $36. This is a lot of tax for me to pay for being in a zero-coupon fund for two months.

I understand year-end capital-gains distributions, but in this case the investor gets nothing. The fund uses a reverse share split, which raises the fund's share price back to its predividend price. I started in this fund with 2,317 shares, and after distributions ended up with the same amount, plus a couple of percentage points of price appreciation -- and a 20% capital-gains liability! My problem is that the taxable capital gain is so much greater than the imputed interest on the bonds. The bonds are accruing interest at 5% to 6% a year. I understand the fund does some trading, but does that account for the other 15%? --Rich Schneider

Rich,

It's not as bad as you think.

Before I explain why, let me explain a bit about the kind of fund we're talking about, for readers who aren't familiar with it.

A target maturity fund attempts to mimic the performance of a zero-coupon bond. Regular bonds pay interest: for example, if you buy a bond with a 6% coupon for $1,000, its face value, the bond pays you $60 a year until it matures, at which point you get your $1,000 back. Zero-coupon bonds have no coupons (hence the name), so they pay no interest. Instead, they are priced at a steep discount to face value. For example, a $1,000 zero-coupon bond maturing in 10 years might cost $500.

Target maturity funds are designed to reach a target share price in a certain year, at which point they liquidate. Your fund aims to reach its price target of about $100 in 2020 (hence its name). The American Century target maturity funds, which invest in Treasury zeros, aim to match the performance of a Treasury zero maturing in the target year.

There are a couple of important differences, however, between owning shares of a target maturity fund and owning zeros that mature in the target year.

The first has to do with interest. Zeros don't pay it.

A target maturity fund, on the other hand, "is required by the

Internal Revenue Service

to distribute dividends based on the zeros' imputed interest," says American Century's

explanation of how these funds work.

Imputed interest is effectively the interest you would have received if the bonds carried coupons. Whether you own zeros or target maturity fund shares, you have to pay tax on them each year.

Obviously, like any mutual fund, a target maturity fund also must distribute capital gains each year, and that's the second difference between owning target maturity fund shares and owning zeros. If you own zeros, you pay capital-gains tax only when you sell bonds for more than their imputed value. But if you're a fund shareholder and the fund has taken capital gains, you're going to pay tax on them.

Why Such a Big Distribution?

Rich, you say you are aware that most funds distribute capital gains at year-end but were blindsided by the size of the distribution on your fund. Indeed, it was a huge distribution. The fund distributed a total of $7.26 on a net asset value of $36.11. Of the total, $2.06 was the dividend and $5.20 was capital gains.

No other American Century target maturity fund distributed anywhere near that much in capital gains. So what happened?

What happened is that the fund racked up huge gains last year, and lots of investors cashed out, socking those who stayed with the capital-gains distribution.

All bonds and bond funds do well when interest rates are dropping, but zero-coupon bonds and funds do the best. So as Treasury yields headed steadily lower last year, the prices of zeros and of target maturity fund shares shot up, as you can see from this

chart of BTTTX. Consequently, many investors sold. David Schroder, the fund's manager, said that in the year ended Oct. 31, 1998, the period for which capital gains were calculated, the fund's assets dropped to $455 million from $573 million, and the number of shares shrank to 11.8 million from 19.5 million.

The large capital gain happened because the fund, which is fully invested, had to sell securities to meet redemptions when prices were high, Schroeder says. The manager says he tries to sell the highest-cost securities first in order to minimize the tax impact, "but there's only so much we can do."

Examining the Reverse Split

So, all the gains that got taken in order to let the sellers out were distributed to the remaining shareholders. Why shouldn't that upset you? For two reasons.

First, the sellers don't get to avoid paying capital-gains tax. They get taxed on their gains on their shares.

The second reason has to do with the devilishly complicated reverse share split you mentioned. No shame in this, but I think you partially misunderstand it.

When a normal mutual fund makes a distribution, its net asset value drops by the amount of the distribution. If you are reinvesting your distributions, they go to purchase additional shares at the lower, postdistribution price. Target maturity firms work the same way. If you reinvest your distributions, they go to purchase additional shares at the lower, postdistribution price.

But immediately after the distribution, a reverse share split is performed. Why? If a target maturity fund's share price dropped every time it made a distribution, the fund would never reach its target price of $100 a share. The reverse share split returns the share price to its predistribution level. Depending on whether you reinvested your dividend or took the cash, you would have either the same number of shares as before, or fewer shares.

It's easiest to understand if you think in terms of the total value of your investment.

In a regular fund, if you take your distributions in cash, the total value of your investment will be less after the distribution than before; you'll have the same number of shares at a lower price. If you reinvest, the total value will be the same after as before; you'll have more shares at a lower price.

In a target maturity fund, if you take your distributions in cash, the total value of your investment will be less; due to the reverse split, you'll have fewer shares than before -- but at the same price. If you reinvest, the total value will be the same; you'll have the same number of shares at the same price.

The fact that you have the same number of shares now as before doesn't mean the fund hasn't given you anything. It's given you your predistribution share price back. Remember, if you'd taken your distribution in cash, you'd have fewer shares now than you had before the distribution.

Cap Gains Taxes: Pay Now or Pay Later?

How does this affect you from a capital-gains standpoint? Assuming you don't intend to hold this fund till maturity, you're going to sell your shares someday, hopefully at a gain. You're paying a big tax bill this year, but that will mean a smaller tax bill when you go to sell. Here's how it works:

    You'll be taxed on the difference between the price at which you bought your shares -- your basis -- and the price at which you sell. But you're allowed to increase your basis by the same factor that was used to calculate the reverse share split. An example, courtesy of American Century: If a reverse share split leaves you with 80% of the shares you had before, you're allowed to divide your basis by 0.8. So if you bought 100 shares at $20, in the event of a 4-for-5 reverse split your basis in those shares would rise to $25 ($20 / 0.8). But obviously, the size of that factor, 0.8 in the example, depends on the size of the distribution that triggered the reverse share split. The bigger the distribution, the smaller the factor. (The bigger the distribution, the fewer shares someone who took their distributions in cash would wind up with.) The smaller the factor, the more your basis goes up when you divide by it. The reverse split BTTTX underwent on Dec. 11 was roughly at the rate of 0.8-to-1, or 4-for-5, using whole numbers. So if you bought your shares in October for about $35, your basis in them is now about $43.75. That means you'll pay less tax later.

Elizabeth Roy answers your bond fund questions each Friday. Dagen McDowell answers your mutual fund questions Monday through Thursday. Send questions on either topic to

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