Plunging Stocks Make Taxes an Afterthought

Still, make sure you don't get hit with any capital gains taxes come April.
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The bad news is that you probably lost your shirt this year. The good news, sort of, is that your pain probably won't be compounded by a fat tax bill come April.

Thanks to the potent cocktail of too-high valuations, sagging economic growth and brutal terrorist attacks, the average U.S. stock fund has lost more than a quarter of its value over the past 12 months -- worse than any calendar-year loss in the past 30 years. This is obviously bad, but the gritty tax world provides us with a meek silver lining: Funds in the red probably won't be saddling you with taxable capital gains distributions on top of your losses. In fact, the average U.S. stock fund's booked trades currently net out to a loss that equals 14% of its assets.

"You'd think any

fund manager paying even the slightest attention to taxes could avoid a distribution this year," says Russ Kinnel, director of fund analysis at Chicago fund-tracker Morningstar. "I'd assume very few managers will be making distributions. Distributions assume they have gains to offset. I wish more did, but that's not the case."

Here's how capital gains distributions work: When your fund's stock and bond sales lead to more profits than losses, it has to pay those excess gains to you. If you own the fund in a tax-deferred account like a 401(k) or individual retirement account, you don't owe any taxes until you withdraw your money. But if you own the fund in a standard account, you usually have to pay 20% of that money to unsmiling Uncle Sam even if you hang on to your fund shares. That could make a lousy year downright miserable.

Both Main Street investors and Wall Street types worry about distributions at this time of year because most funds close their books in October. The former are naturally concerned about their tax bills, while the latter fear a wave of selling as fund managers scramble to dump losers and book losses. In the wake of 1999's steep gains, funds set a record for distributions with $325 billion in payouts, easily eclipsing the $238 billion shelled out a year earlier. But this year's losses mean neither fund investors nor market pundits have much reason for concern.

"I'd expect a lot of funds have harvested losses," says Ron Roge, a financial adviser based in Bohemia, N.Y. "The funds we're talking to are saying there will be no cap gains. We're hoping they've all done the right thing and canceled out any gains with losses."

It's hard to imagine fund managers had much choice when you consider the sheer breadth of the stock market's malaise. On Monday we

noted that every sector-fund category finished the third quarter in the red. Over the past 12 months, only real estate funds are in the black; each sector-fund category averages net trading losses or modest gains that managers could offset by dumping a few of many losers.

As you might expect, the same goes for diversified funds, which are usually a bigger chunk of investors' portfolios. Aside from small-cap value funds, all are averaging losses over the past year, and their capital gains exposure is either negative or narrowly positive. Growth funds' outsize losses this year aren't surprising, since most made big bets on the cratering tech sector. Strictly from a tax perspective, it also helps that they got most of their money as now-ravaged shares hit their peaks.

"Popular growth funds took in most of their money in 1998, 1999 and the first half of 2000, so they have a lot of high-cost shares" that could be sold for a loss, says Kinnel. "Not only did growth funds have high inflows in 1999, but they already made big distributions in 2000."

At the same time, you shouldn't ignore the specter of capital gains distributions because they aren't necessarily impossible. An older stock fund, for instance, might have sold long-held shares for a profit this year to meet rising redemptions. That could trigger cap-gains distribution. How bad would that be? Let's say you invested $10,000 at $10 a share in the average domestic stock fund a year ago. Today, that investment would be worth less than $7,500. Now imagine the fund pays a $1 per share cap-gains distribution. In addition to your more than $2,500 paper loss, you'd owe $200 in taxes if you didn't offset the gain by selling a losing fund or stock.

A quick screen for funds with above-average assets and above-average cap-gains exposure turns up 10 funds with booked gains adding up to at least half their assets. Most of them, like the closed

(SEQUX) - Get Report

Sequoia fund and

(FRBFX) - Get Report

John Hancock Regional Bank fund, made the list by having several long-held financial stocks that are trading above the fund's purchase price.

While taxes are less of a worry this year, it's still worth your time to call your fund companies or check their Web sites to see if they're expecting to make a taxable payout. If so, you can scour your portfolio for a loser to offset the gain.

And if you're thinking about buying a fund now, make sure you're not buying shares just prior to a cap-gains distribution. Doing so would force you to pay taxes on gains that aren't even yours. If there's anything more annoying than paying taxes on a sagging fund, that might be it.

Ian McDonald writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to

imcdonald@thestreet.com, but he cannot give specific financial advice.