Fund Investors Face Risk of Tax Hit Despite Losses

WSJ Tax article
Fund Investors Face Risk of Tax Hit Despite Losses Many Managers Are Planning Capital-Gains Distributions Before the End of This Year

OCTOBER 22, 2008


For most mutual-fund investors, it’s been an abysmal year. The average U.S. diversified stock fund is down 33% through Monday, according to Morningstar Inc. Foreign stock funds have also posted steep declines, as have funds in most other categories.

And some investors may have to pay hefty tax bills on their losing funds anyway.

At issue are year-end capital-gains distributions. Mutual funds typically pay net capital gains to investors around the end of each year. These payments generally are taxable if the investments are held in a taxable account, rather than in a 401(k) plan or other tax-favored retirement account.

Considering diving back into a stock fund in the coming weeks? Keep these points in mind:

* Contact the fund first to see if it’s planning a taxable capital- gains payout.
* If the payout is significant, consider buying another fund or waiting until after the qualifying date.
* You also can invest in the fund in a tax- advantaged account.

Despite the stock market’s nose dive, many funds are likely to make year-end capital-gains distributions this year, fund managers and financial advisers predict. That means it may be a good time to consider selling some underperforming funds before they make a taxable distribution. It also means that bargain-hunters looking to get back into the market now need to be careful. Otherwise they could be saddled with a stiff tax bill that could easily have been avoided.

“Many people are looking for a time to step back into the market,” says Gary Schatsky, a fee-only financial adviser based in New York. If they’re planning on doing so through a taxable account at mutual funds, “they’d better be aware of the distribution dates of the mutual fund — and either wait to invest until after that date or find an alternative that doesn’t have onerous tax consequences.”

Most capital-gains payouts are made in December, and some fund families have already published preliminary 2008 payout estimates, based on results through late September, or will do so soon. For example, OppenheimerFunds says its Developing Markets fund, based on results through late September, had estimated short- and long-term capital gains of nearly $7.20 a share, or almost 20% of net asset value.

Why? “Emerging markets as a whole have done extremely well over the past three to five years, and as a result, the manager decided to close out some long-term holdings,” a spokesman says. Another reason: A new portfolio manager joined the fund last year, and the fund “underwent a significant reorientation and consolidation of its holdings,” he says. The company also says its Global Opportunities fund had estimated gains of around $3 a share, or more than 11% of its net asset value.

At T. Rowe Price Group, the number of funds making capital-gains distributions this year “has not declined very much,” says Greg Hinkle, treasurer of the T. Rowe Price Funds. “We had 50 funds that made capital-gains distributions last year.” Right now, he estimates that 42 funds will make distributions this year. But the total amount of those payments “is estimated to be less than half of last year’s total,” he says.

Vanguard Group “doesn’t expect more than a handful of capital-gains distributions for 2008, and those distributions will be on the modest side,” a spokesman says.

A Fidelity Investments spokesman says it’s difficult to give details on capital-gains payouts just yet. “However, broadly speaking, we believe only a few Fidelity funds will pay distributions of capital gains this year, unlike in recent years, and that the amount of the distributions will generally be significantly lower,” the spokesman says.

Some of Capital Research and Management Co.’s American Funds are likely to make year-end payouts, says Maura Griffin, a spokeswoman. Among them is the New Perspective fund, a global blue-chip stock fund. Based on Sept. 30 results, the fund estimates a payout of 7% to 9% of its net asset value, according to the group’s Web site. The distribution will be paid Dec. 24 to shareholders of record Dec. 23.

Similarly, the company expects its New World fund, a global growth fund, to pay out around 4% to 6% of its net asset value, with the same distribution and record dates as the New Perspective fund, Ms. Griffin says. Most other funds in the family are expected to make much smaller payouts, or none at all, she says.

“Investors may wonder why, in a declining market, capital gains could be possible,” Ms. Griffin says. “These realized gains are not short-term but are correlated to stocks we held for several years that had strengthened before fund managers chose to sell them.”

Before investing a significant amount of money in a fund in coming weeks, check to see if the fund is likely to be making a year-end payout, and if so, how much and when. Many fund organizations post this information on their Web sites. Then crunch the numbers to see if the payout will increase your taxes significantly. If the answer is yes, consider another fund — or wait to invest until after the date to qualify for the payment.

This doesn’t mean investors should automatically shy away from any fund planning year-end distributions. After all, one of the easiest ways to make a bad mistake is to make an investment decision based solely on tax considerations, instead of investment fundamentals.

“In markets with big daily moves, keep investment considerations foremost,” says T. Rowe Price’s Mr. Hinkle. “If you stay out of a fund for one day to avoid a 5% distribution, but lose out on a 6% or 7% upward market move that day, you’ve lost ground.”

Nobody knows the exact amount of gains that will be handed out this year, or even how many funds will be making them, since the accounting period for the year isn’t over yet. But fund managers say the total number of funds making payments, as well as the dollar amounts, are expected to be far below a year ago, when funds made their largest payouts in history.

According to the Investment Company Institute, mutual funds distributed nearly $415 billion in capital gains to shareholders in 2007. That total, which includes both paid and reinvested capital gains, was up sharply from about $257 billion in 2006. About 36% of the 2007 distributions were paid to taxable household accounts, the ICI says. Stock funds typically account for the bulk of the distributions.

Investors can offset capital gains and losses on a dollar-for-dollar basis, with no limit. If your losses exceed your gains, or if you have no gains at all, you typically can deduct as much as $3,000 of net capital losses ($1,500 if you’re married and filing separately from your spouse) from wages and other ordinary income. Additional losses are carried over into future years.

But if you sell and decide to reinvest the proceeds quickly, be careful you don’t run afoul of what are known as the “wash sale” rules. You can’t deduct losses from sales of stock or other securities in a wash sale, which typically occurs when you sell or trade securities at a loss and buy the same, or “substantially identical,” securities within 30 days before or after a sale.

If an investor does sink money into a fund just before a sizable year-end distribution, there is at least one consolation, according to the Ernst & Young Tax Guide 2008. Your higher basis will reduce the amount of any capital gain on a later sale — or, if you sell the fund at a loss, it will increase the size of your capital loss. However, the guide says, “if you want to limit your current tax liability and lower your basis in the shares, you should delay your purchase of fund shares until after the record date for the distribution.”

Many workers will pay higher Social Security taxes next year.

The maximum amount of earnings subject to the Social Security tax in 2009 will be $106,800, the Social Security Administration said. That’s up $4,800, or 4.7%, from $102,000 this year. This dollar threshold is adjusted annually to reflect changes in average wages.

Thus the maximum additional Social Security tax that might be collected on an employee earning above the 2008 wage base will be $297.60, says Avram Sacks, Social Security law analyst at CCH, which provides tax and payroll information and software and is part of Wolters Kluwer Law & Business.

“Taxes for self-employed individuals use the same earnings base, but the rates are double those of employees, since the self-employed must also pay the ’employer’ portion of the taxes,” says Mr. Sacks. “This means that high-earning, self-employed individuals may owe as much as $595.20 in additional self-employment tax in 2009. However, they can recoup some of this amount through a deduction on their federal income tax.”

Of the estimated 164 million workers who will pay Social Security taxes in 2009, about 11 million will pay higher taxes due to this increase in the taxable minimum, the Social Security Administration said.

The rate for the “hospital insurance,” or Medicare, tax stays at 1.45%. This applies to every dollar you earn.

About Jorge Costales

- Cuban Exile [veni] - Raised in Miami [vidi] - American Citizen [vici]
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