Funds: The $20 billion tax time bomb
This time each year mutual funds tell investors their share of the tax hit for a year's worth of trading. The numbers are looking big.
NEW YORK (Money) -- Mutual fund returns are lighting up the charts, but before you celebrate, make an appointment with your accountant.
The average stock mutual fund has gained roughly 10 percent this year, putting funds on track for the third straight year of positive returns. But it's tax crunch time in the fund world, and all signs are pointing to bigger taxable distributions than investors have seen for some time - fund investors could pay a total of $20 billion for 2006, according to one estimate by Lipper, a fund research firm. That's up from $15.2 billion in taxable distributions last year.
Remember, even if you don't sell your fund shares, you're on the hook for moves made by the fund manager unless you own the fund in a tax-deferred account such as a 401(k). Qualified stock dividends and long-term capital gains are typically taxed at 15 percent; interest income and short-term gains will be levied at federal income tax rates, which can be as high as 35 percent.
One reason for the increased taxes is that the market has been especially volatile this year. Large caps overtook small caps as the market's favorites, for example, while emerging markets, homebuilding and energy stocks have moved abruptly in and out of favor. To stay on top of these market shifts, many fund managers traded more frequently.
"All these changes have resulted in higher taxable gains," says Tom Roseen, senior research analyst at Lipper.
And compared with past years, fund groups also have fewer bookkeeping tricks to minimize their distributions. Funds had been able to offset capital gains with losses that were racked up during the 2000-2002 bear market. But "after three years of gains, many funds have used up much of their tax-loss carry forwards," says Duncan Richardson, chief investment officer at Eaton Vance.
Still, not every fund is poised to deliver a tax bomb. The size of the distributions will vary widely, depending on the type of fund and the manager's investing style. But you are most likely to find the biggest taxable gains among funds that have enjoyed the strongest recent returns. Consider it the price of success.
For example, many overseas funds, which have delivered healthy gains this year, are likely to report heftier distributions.
In its estimate, American Century reports that its International Opportunities (AIOIX (Charts) fund will pay out long term capital gains per share of $2.20, short-term gains of $0.54, plus $0.01 in ordinary income. At its current share price of $11.13, that distribution would amount to 25 percent of of the fund's net asset value. That's about the same as last year, but much more than in its 3 percent payout in 2004.
Larger distributions can also be expected for funds that buy smaller stocks, which have also been on a tear. Vanguard Explorer (VEXPX (Charts), a small- and mid-cap portfolio, is reporting that distributions are likely to amount to 11 percent of net asset value, versus 9 percent last year.
Some of the biggest tax bills, however, will result from internal changes rather than market shifts. At Fidelity New Millennium (FMILX (Charts), where John Roth recently succeeded longtime manager Neil Miller, taxable distributions are estimated to be a whopping 30 percent of the share price. Says Fidelity spokesperson Sophie Launay, "Nearly half of the shareholders own New Millennium in a tax-deferred account."
If you are looking to invest new money in a mutual fund, you would do best to check its distribution schedule by calling the company or checking its Web site. You don't want to put your money in right before a payout, since you will end up paying taxes on gains you did not benefit from.
And to minimize your tax bill in the future, seek out tax-efficient funds for your taxable account, suggests Roseen, such as index funds or tax managed funds, which deliver fewer taxable distributions. That way you'll keep more of what you earn.
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