How to Avoid Another Tax Headache From Big Distributions

NEW YORK (MainStreet) — A while back we cautioned that year-end mutual fund distributions could be bigger than usual this year. Well, it turns out that's just what's happening, causing a tax headache for many investors who have not organized their portfolios in the most tax-efficient way.

But although you may be stuck with taxes on this year's distributions, reinvesting those payouts in different funds or in tax-favored accounts could reduce the problem in the future.

As expected, the big stock gains of the past few years are coming home to roost. And, unfortunately, the bull market has being going on long enough that many funds have run out of offsetting losses. Some experts believe the average actively managed fund will pay nearly 20% of its share price in year-end distribution. An investor with a $10,000 holding would thus get $2,000, which would be taxable unless the fund was held in a tax-favored account such as a traditional IRA or 401(k).

Funds are required to pay to investors the net profits on stocks or other holdings sold during the year. So in December fund managers subtract losses from gains to arrive at the net figure. If it's a profit, it is paid to the investor, who can opt to get a check or have the money reinvested in more shares of the same or some other fund.

Because these payouts reduce the fund's assets, the share price drops an equivalent amount. So a $100-per-share fund that pays $20 becomes an $80 fund overnight. The investor still has $100 in holdings, only now it's divided between the original holding and new cash or whatever the cash was used to buy.

If the fund has net losses for the year, the fund can carry them forward to subtract from gains in future years. Many funds had whopping losses in 2008 and have been using them to offset gains ever since. Now that well is running dry. According to some accounts, this year's stock market volatility prompted many fund managers to lock in gains by selling winners, and with no offsetting losses that produces big distributions.

Though the final distribution amounts will not be known for two or three more weeks, many fund companies are posting estimates that should be pretty close. To soften the blow, an investor can sell other investments that have lost money. But that makes sense only if the losers are candidates for sale anyway, which means the investor figures they'll continue to do poorly.

Aside from that, the investor should think about future years. Typically, investors use distributions to buy more shares of the same fund - but you don't have to. You could tell the fund company to buy shares in a different fund that's less likely to pay big distributions in the future. Or you could have the distribution put into a money-market fund while you think it over.

As a group, actively managed funds, whose managers buy and sell frequently in pursuit of hot holdings, tend to have larger distributions than passively managed funds -- or index funds — that use a buy-and-hold strategy. An investor sick of big distributions but unwilling to sell the offending fund could reduce payout risk over time by channeling those distributions to a comparable index fund.

Another strategy: Use the distribution to invest more in a tax-favored account such as an IRA or 401(k). You could invest in the same fund but not face annual taxes on distributions because in those accounts taxes are due only after fund shares are sold (http://www.bankingmyway.com/save/money-market/what-cost-basis-really-means).

You can use the same strategy for new investments: Use those tax-favored accounts for actively managed funds prone to big distributions, and invest in index funds in your taxable accounts.

— By Jeff Brown for MainStreet

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