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Mutual Funds
How to limit fund tax bite
October 7, 1999: 1:10 p.m. ET

Financial planners say you shouldn't feel helpless about your fund's tax tab
By Staff Writer Martine Costello
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NEW YORK (CNNfn) - Financial adviser Ed Slott says he's always astounded by the number of people who get snared in what he calls the "mutual fund tax trap."
     Investors race to buy a top-performing fund before the end of the year, only to get slapped with a big tax bill for the fund's gains even though they've owned it for just a few weeks.
     The "trap" occurs when people invest before an annual deadline required by law that funds use to designate official shareholders. Buy before the date, you'll get a bill for that year's gains. Buy afterwards, you won't.
     "Novice investors think they need to buy before that date," said Slott, a personal finance expert and author. "You should always buy after the date."
     Fund investors may not have much say when a manager sells a stock or bond and generates a capital gain, but financial advisers say there are many ways to limit tax pain. And even though tax season is months away, now is a great time to get started.
    
Avoid the tax trap

     First, make sure you call the fund company to check its "record date" before you plan to invest or sell shares.
     Fund companies pick a date to designate shareholders who will receive "distributions." A distribution is mutual-fund jargon for a dividend payment, short-term capital gains or long-term capital gains.
     By law, fund companies have to distribute 90 percent of their income every year by this date, Slott said. The date can be anytime in the last quarter, but is often in December.
    
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     You should check with fund companies to find out if they will be making capital gains distributions, said Dave Mangefrida, national director of asset management tax services at Ernst & Young in Washington. They're not obligated to tell you, but most will, he said.
     Otherwise you can find out about distributions in your regular statements or in February, when funds send out 1099 tax forms, said Laura Lallos, an analyst at Chicago fund-tracker Morningstar.
     You'll pay a rate of 20 percent on capital gains distributions. But you'll pay regular income-tax rates of up to 39.6 percent on short-term capital gains of less than a year, and income on bonds or stock dividends -- even if you reinvest the money into the fund, Lallos said.
    
Distribution warning signs?

     How can you tell if a fund will have a capital gains distribution? A manager change, or a change in an investing strategy, can be a big giveaway, Lallos said. In both cases, the fund will be making a lot of trades.
     And funds that have been hit with a lot of redemptions may have to sell stocks to come up with the cash for fleeing shareholders. Likewise, top performing funds that invest heavily in soaring Internet and technology stocks could deliver a painful tax punch.
    
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     Baron Growth Fund, Evergreen Fund, Founders Passport Fund and Merrill Lynch Growth Fund are among a new list compiled by Morningstar of possible "tax suspects."
     But Lallos said it isn't so much an issue of whether a fund makes a distribution, but how big the distribution is compared to the net asset value, or NAV.
     "If it's a considerable chunk of a fund's return (that) gets distributed every year, then it adds up," Lallos said.
    
To sell or not to sell?

     While everybody agrees you shouldn't buy a fund before a capital gains distribution, they disagree about whether you should bail out of a fund to avoid a tax bill.
     Charles Hamowy, senior financial adviser at American Express Financial Advisors, thinks an investor is better off selling a fund that is making a distribution and putting the cash in a fund that isn't.
     Hamowy said you may be generating a capital gain with the sale of your shares, but it probably will be less than the distribution. Keep in mind, however, that if you want to go back to the first fund you'll have to wait 31 days under the law.
     "You can avoid being a victim," Hamowy said.
     But Joel Dickson, a principal at fund giant Vanguard Group, said investors shouldn't sell just because of a distribution.
     "Distributions are no reason to panic," Dickson said. "What you're doing if you sell is realizing all of your gains. You're selling your fund and you're creating a taxable event."
     For example, let's say you bought a fund for $9 a share. The fund is trading at $11 and has announced a distribution of $1. You sell to avoid that distribution and generate an even bigger capital gain of $2.
     "You've accelerated your liability," Dickson said.
     But Dickson would sell if the fund is declaring a short-term gain, because the tax hit could be steeper.
    
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     "You have to take each situation individually," Dickson said. "Don't make a knee-jerk reaction."
     Lallos argues that timing your mutual-fund trades because of tax reasons will conflict with long-term investing goals.
     "People shouldn't be trading funds with tax concerns as their motives," Lallos said.
    
Not always a capital gains

     Another thing to keep in mind is that you won't always get a distribution. A manager may decide not to sell stocks, or he may do a great job of balancing gains and losses to negate a capital gains punch.
     Some big winners in 1999, like the Van Wagoner funds, are going out of their way to tell people that there will be limited or no distributions.
     Neither Van Wagoner Emerging Growth Fund or Van Wagoner Micro-Cap Fund will have a distribution, according to new estimates released Wednesday, Peter Chris, a spokesman for the San Francisco-based company, said.
     Van Wagoner Emerging Growth Fund is up 143.5 percent year to date as of Sept. 30, while the Micro-Cap Fund is up 109.4 percent in the same time, according to Morningstar.
     The three other funds will take distributions that are 6.5 percent to 14.5 percent of the NAV, Chris said. The funds have gains ranging from 64 percent to 119 percent year to date as of Sept. 30, Morningstar said.
     "We are thrilled . These are extremely low (distributions) given all the gains," Chris said.
     The Monument Internet Fund also announced several weeks ago it would avoid most capital gains by using a buy-and-hold approach and adding to positions slowly over time. The fund is up 101.6 percent as of Sept. 30, Morningstar said.
    
What else can you do?

     Unfortunately, the hard truth is most funds don't give much thought to tax implications, said Mangefrida of Ernst & Young.
     "Managers feel if they have to worry about taxes it will hurt their overall performance," Mangefrida said. "But for investors, it does matter."
     Lallos, of Morningstar, recommends investors look for funds with veteran managers who have made tax concerns a priority. There are also about 30 "tax-managed" mutual funds that take taxes into account with all trading decisions.
     You should put the funds that aren't tax efficient in tax-deferred IRAs and 401(k) plans, and put everything else -- index funds and tax-managed funds -- in your traditional investing account, she said.
     Dickson, of Vanguard, said investors should look at their overall portfolio when making decisions about taxes. If a fund has a capital gains distribution, perhaps there is a losing fund that you can sell at a loss to offset the gain.
     You can use four different options to calculate your gains and losses, depending on your needs.
     One method, called "first in, first out," means you sell your longest-held shares first. This is the default method unless you choose another. (Once you pick one method you have to stick with it unless you get permission from the I.R.S. to change).
     Another method, "specific identification," allows you to identify which individual shares you want to sell. It requires painstaking record-keeping.
     Fund companies use "average-cost single-category method," which calculates an average cost per share. A fourth option, "average cost double category method," calculates a separate average cost for short-term and long-term shares.
     "You have some flexibility," Dickson said. Back to top

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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.