Mutual Fund Tax Issues Are Back

If you are invested or intend to invest in a mutual fund before the end of this year, there are several things you need to know to avoid a big tax surprise. According to many industry experts, capital gain distributions from mutual funds could top $200 billion in 2006, the third largest distribution in history. The two previous largest years were $326 billion in 2000 at the “top of the market” and $238 billion in 1999, according to the Investment Company Institute. When the markets dropped significantly in 2001 and 2002, many mutual funds took heavy losses and tax distributions became minimal. However, according to George Ross, CPA for Bartlett, Pringle & Wolf, LLP, “taxpayers may be in for a big surprise this year, as many taxpayers have used up all their carry forward losses from previous years and we are finding in our year-end reviews that fewer and fewer clients have unrealized losses to offset potential gains being distributed this year.”

What has prompted the resurgence of these large distributions? For starters, mutual funds typically pass through virtually all their earnings to the shareholders. This “pass through” of earnings typically includes interest, dividends and capital gains not offset by internal losses. Since the market lows of 2002, the equity markets not only in the US but around the world in general have increased rather substantially along with the internal investments in mutual funds. The chart below illustrates the bull run the markets have experienced over the past four years.

What should investors do? You should call your advisor or mutual fund companies immediately to understand what your anticipated gains will be for the year and which date they will be declared for current investors. You can then decide if action needs to be taken. If the tax impact looks like it could be substantial, you may want to consider taking advantage of one of the following options:

One option is to sell the fund before the declared date, thus avoiding the distribution altogether. However, this action will trigger a taxable event regarding the investment either creating a gain or a loss.

Another option is to sell other investments that may be at a loss to offset the gains. However, if you take this route you have to be comfortable staying out of the “sold-loss” investment for a period of time. According to Mr. Ross, “the IRS has provisions in the tax code called, ‘wash sale rules,’ that specifically address the practice of selling an investment at a loss and immediately repurchasing it.

“The rule states that if you sell an investment for a loss and buy it back within the thirty-day period before or after the loss-sale date,” Ross continued, “this will negate your ability to immediately claim the loss for tax purposes.” A further option is to do nothing and just pay the tax if that makes the most sense for your situation.

One question that often arises is: “If I plan on buying mutual funds before the end of the year, do I have to concern myself with any of this?” The answer is clearly “yes.” If you are planning on buying a fund before year’s end, you should definitely understand what the tax consequences will be for the purchase before you make your purchase. If you own a fund just one day before the declared date, you will be responsible for the tax distribution. For example, if you were to purchase 10,000 shares of a fund on December 20 and that fund declared a $1 long term capital gain distribution for investors of record in the fund, then on December 22 you will receive a “tax bill” for approximately $10,000 of long-term capital gains ($1 distribution per share owned), even though you are a new investor in the fund. If this is the case, it may behoove you to wait to invest a few days after the investor of record date is declared. Obviously this does not apply to qualified or tax-deferred accounts.

Taking these steps may help you reduce the capital gain impact this year, but issues like this also raise questions about future years. If you’re asking yourself, “What can I do going forward to be more proactive with tax planning?” here’s an additional suggestion: Over the years more and more “tax-sensitive” investments and programs have been developed to address this issue. You can also structure future investments more wisely. For example, if you know you have a fund with a potential for high turnover and high tax output, it may be advantageous to have that investment reside in your qualified plan such as your IRA or 401k, which grow tax-deferred.

Investments and taxes are complicated and a great deal of care and thought needs to be placed into long-term strategies that match the goals and objectives of your “life plans.” Before you make any future strategic decisions, just remember that it is always wise to seek proper guidance “ahead of time” to help maximize results by incorporating advice from your CPA, financial advisor and estate planning attorney.