Funds Increase Year-End Payments
Capital-Gains Distributions Expected to
Be
Highest Since 2000; Avoiding the Tax
Trap
By TOM HERMAN and DIYA GULLAPALLI
Staff Reporters of THE
Mutual funds are expected to make their largest year-end
capital-gains payouts since 2000 this year. That means many people will need to
be especially careful about the timing of new investments in mutual funds in
the final weeks of this year to avoid a bloated tax bill.
Mutual funds that have net gains on securities they sold typically
distribute the gains to shareholders near the end of each year, usually in
December. While getting a year-end check sounds appealing, these payments
typically are taxable -- except when funds are held in a tax-favored retirement
account. Thus, if you sink money into a mutual fund late in the year and get a
big payout shortly thereafter, you're essentially getting back some of your own
investment -- and being forced to pay taxes on it.
While the overall stock market has been lackluster so far this
year, some types of stock funds have shown exceptionally large gains, which
could mean high capital-gains payments. Among them are Latin American funds and
funds specializing in natural resources and emerging markets. Other types of
funds may also be making substantial year-end payouts, fund managers say. One
reason: Many funds were able to offset capital gains in recent years with
losses from the bear market of 2000-2002. This year, there are fewer losses
left to use.
Several major mutual-fund companies -- including Fidelity
Investments, Vanguard Group Inc. and T. Rowe Price Group Inc. -- say they
expect to make larger capital-gains distributions to investors than they have
in the past few years. T. Rowe Price expects about a 35% to 40% increase this
year in the average capital-gain distribution from each equity retail fund
expected to make a payout, says Sam Beardsley, a vice president and director of
investment taxation at T. Rowe Price. This is based on "preliminary
estimates and may change," Mr. Beardsley adds. An
example of a fund with a significant payout would be the T. Rowe Price
Financial Services Fund, which Mr. Beardsley says is expected to distribute in
December about 13% of its net asset value.
"More Fidelity funds will pay capital-gains distributions this
year," says John Brockelman, a spokesman for
Fidelity Investments. "The environment of generally rising stock prices as
we've emerged from the bear market has increased the likelihood that funds will
have sold stocks that increased in value." He also said more Fidelity
funds have used up capital losses from prior years, and the firm expects more
variety in the types of funds paying distributions. Fidelity expects to make
information about its fund distributions available to investors in the next few
weeks.
Vanguard Group said it will post information about capital gains on
its Web site and in a shareholder newsletter later this month. "We'll see
a little more in the way of capital-gains distributions to shareholders,"
says Joel Dickson, a tax specialist at Vanguard. "But it's still nowhere
close to what we saw around 2000."
Mutual-fund distributions were particularly plentiful during the
big stock-market boom in the late 1990s. In 2000, funds distributed around $114
billion in capital gains to individual investors in taxable accounts, according
to the Investment Company Institute, a trade association for mutual funds. Then
payouts fell sharply. But they totaled about $22 billion last year, up from $6
billion in 2003, says Brian Reid, chief economist at ICI.
For investors worrying about the fund-payout tax problem this year,
here's some advice from investment pros: Before investing, check to see if that
fund is planning a year-end payment, how much and when, Mr. Beardsley says. If
receiving that distribution will result in a significant tax bill, consider
waiting to invest until after the date to qualify for the payout.
For those considering investing a sizable amount in one chunk,
waiting until just after the record date to make the move "can make a big
difference in savings over time," says ICI spokesman Edward Giltenan.
You don't need to worry about this issue if you're investing in a
fund for a 401(k) plan, individual retirement account or other tax-advantaged
account. But tens of millions of investors do need to pay attention to this
issue: About one-third of the 90 million investors in mutual funds pay taxes on
capital-gains distributions, Mr. Reid says.
Mutual-fund leaders are pressing for federal legislation that Mr. Giltenan of ICI says would allow fund investors to defer
taxes on long-term capital gains distributions from their funds until they
actually sell fund shares. But the congressional agenda is so packed these days
that prospects for recently introduced legislation appear blurry, at best.
This issue highlights a drawback to mutual fund investing for
regular accounts that aren't tax-deferred, says Robert N. Gordon, president of
Twenty-First Securities Corp., a brokerage and investment concern, and
co-author of the 2001 book "Wall Street Secrets for Tax-Efficient
Investing." He urges investors to do their homework carefully. "There
could still be a big surprise even in a flat stock market," since a fund
manager could suddenly sell a stock he's held on to for 20 years, Mr. Gordon
says. Thus, "you owe it to yourself to call the funds and see what the
distributions are this year."
Even so, many investors may want to invest in funds anyway. An
example: someone who expects a fund to rise significantly in value in the weeks
or days before the payout, or someone investing relatively small amounts of
money on a monthly or quarterly basis. After all, investment decisions should
be based on overall factors, not just taxes. But don't ignore tax
considerations, either.
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