Mutual fund investors could be in for a nasty surprise come tax time.
Even if investors haven't sold their shares and the funds haven't performed that well, tax bills could still be hefty this year.
That's because fund managers have been recasting their portfolios, selling stocks that may have had big moves in earlier years. Because of the tax laws governing funds, they must declare a taxable distribution to their investors when the fund realizes those gains, even if the investor is sitting tight and the gains are a couple of years old.
"People will feel they did not make a lot of money (this year), and yet they may well see some significant capital gains taxes due on their funds holdings," said Don Cassidy of Lipper, a fund research firm.
Investors give up 2 percentage points or more of their annual returns to taxes, Lipper has said.
That isn't an issue for people who hold their funds in tax-deferred retirement accounts. Those accounts aren't taxable until you withdraw money from them. (Of course, then they are taxable at income tax rates that could be higher than the current top capital gains rate of 15 percent.)
But investors holding mutual funds in their taxable portfolios can expect quite a hit this year. Many big names are predicting some sizable distributions. For example, Fidelity's Value Strategies Fund and American Century's International Opportunity Fund each will distribute roughly 21 percent of their value, according to Morningstar.
Don't get scared, get smart: here's what to do about it.
Do some math. Look at the funds you own and figure out what your personal gain or loss is in the fund, as well as the planned distribution amount and the date the distribution is planned. If your own position has a loss, but the fund is about to declare big gains, you can sell before the distribution, and take a tax loss.
Sell other funds in which you have losing positions, because you'll be able to use those losses to offset any gains you might take in other funds. You can even sell some shares of a fund, just to lock in your losses on those shares.
Be careful what you buy with the money you reap via selling. You can't buy the same fund within 30 days or the Internal Revenue Service will disallow your losses. You can buy another similar find; for example, trading one tech fund for another. Before you buy a new fund, make sure that you don't buy one just before it makes its own taxable distribution, or you'll really get stuck paying taxes on money you didn't earn.
Choose your future funds carefully. Several fund companies offer funds that are explicitly tax managed. Typically, the managers reap losses aggressively and are slow to trade in gains-producing winners.
Morningstar has praised those tax-managed funds issued by Vanguard. Most Eaton Vance funds are tax managed, too, but they carry commissions and can be pricey. Index funds, while not explicitly tax-managed, often produce lower taxable gains than more actively traded funds, simply because they have lower portfolio turnover.
If you want to buy and hold, consider using exchange-traded funds instead of traditional mutual funds. They are structured differently and won't drop a taxable gain in your lap until you decide to sell your shares. The traditional mutual fund industry is so concerned about the competitive disadvantage this lays on their funds that they are petitioning Congress for new rules which would allow them to defer taxable distributions until individual investors sold their own shares. That might be nice but given Washington's budget crunch, don't hold your breath while you wait.
