Taxable distributions may shock fund investors

Talk about kicking investors when they're down.

A required year-end practice by mutual funds is about to whack many people with capital gains taxes at the cruelest of times: when funds already have declined by as much as 40 percent this year.

Even though a fund's value has declined, it may have realized capital gains over the course of the year - profits from selling specific securities in the portfolio. Usually such gains draw no more than brief grumbles at most from individual investors because they know that's part of the price they pay for investing in mutual funds.

But when individuals find out they have to pay taxes for gains in one of the worst years in stock market history, it's likely to stir shock or outrage among those who pay little attention to the process.

After all, 99.9 percent of all U.S. equity open-end funds had negative returns for 2008 through Oct. 31 and the average fund had lost 35 percent, according to Morningstar Inc.

"Even though we've experienced a great deal of losses as investors this year, we could have fairly sizable distributions passed through to us," said Tom Roseen, an analyst with fund tracker Lipper Inc. "What an insult on top of injury."

Getting stuck paying capital gains even when your funds decline in value is rare but not unheard of.

Still, how could it happen?

The Internal Revenue Service requires mutual funds to distribute substantially all (at least 98 percent) of their income to their shareholders, who must then report the distributions as income and pay taxes on them. This year, funds realized gains from stocks sold before their value plummeted this fall.

Then when the financial crisis hit, investors pulled a record $46.5 billion out of U.S. mutual funds in September and another $40.5 billion in October, according to Arcata, Calif.-based AMG Data Services. The forced sell-off led funds to record significantly more capital gains.

If your fund investments are in tax-sheltered retirement vehicles such as 401(k)s or IRAs, you needn't be concerned because there are no taxable distributions. But shareholders of other funds face what could be a significant double whammy with ill-timed distributions on top of their whopping personal losses.

Investors in buy-and-hold mutual funds paid a record $33.8 billion in capital gains taxes in 2007 - painful but at least understandable for a year dominated by a bull market.

While 2008 distributions are not expected to reach last year's record level, investors could feel substantial pain from funds that have been on a roll in recent years and had built up a lot of unrealized capital gains. Emerging market funds, some other international funds and funds invested in commodities and natural resources stocks all fall into that category.

Long-term capital gains are taxed at 15 percent for most taxpayers and 0 percent for low-bracket taxpayers. Short-term capital gains, profits on the sale of securities held less than a year, are taxed as regular income.

Individuals can sell funds now to try to dodge the distributions, but such moves often are ill-advised.

"In most cases you're probably not going to be better off by doing that," said Christopher Davis, a fund analyst at Chicago-based Morningstar. "Most people really can't game the system. Especially if you're a long-term owner and you've made money, you're going to pay taxes sooner or later."

But there are some steps investors can take that could help:

Check now: Mutual funds typically make distributions in early to mid-December but issue estimates in November. Many funds will not make any distributions at all this year; others might distribute capital gains amounting to as much as 5 percent of your holdings. Go to your fund companies' Web sites or call them to learn what distributions might be upcoming.

Consult with an adviser: If you bought your mutual funds through an investment adviser, ask them what tax liabilities you will face and whether you should take action to head them off.

"Make decisions in consultation with your adviser," said Roseen. "You don't want to go out there blindly buying and selling."

Consider selling: It may be time to dump an underperforming fund - especially if you've only held it a short time and it's about to make a distribution. You can take a tax loss to offset capital gains and even ordinary income by up to $3,000, and carry any excess losses forward.

But unless the fund has poor future prospects, think long and hard first.

Greg Hinkle, treasurer of funds for mutual fund company T. Rowe Price, says investors should be careful not to let tax considerations override investment considerations. He notes that if an investor with $100,000 in a fund is slapped with a capital gains distribution of 5 percent, or $5,000, the bottom-line cost with state and federal taxes factored in might be $1,000 - not insubstantial but only part of the overall picture.

"If you go to extraordinary lengths to try to eliminate that cost and then the market goes up 6 or 7 percent, you could save $1,000 and lose out on $6,000 or $7,000 in appreciation," he said.

Wait to buy: If you are ready to buy into a fund, wait until it goes "ex-dividend" - meaning it has made the distribution. That way you get in at a cheaper price - because a fund's net asset value drops by the amount of the distribution - and don't inherit that tax penalty.

Have a tax-smart portfolio: Keep funds that are more tax-efficient in your taxable account and hold other, less-tax-advantaged ones in your sheltered accounts.

Four types of funds are more tax-efficient, according to Roseen: index funds that have minimal capital gains because there's not much turnover; exchange-traded funds, which have no capital gains because of their redemption process; municipal bond funds and tax-managed funds.