Fund tax bombs could top $24 billion

NEW YORK (Money Magazine) -- Mutual fund companies have begun to estimate this year's taxable distributions - and your tax bill is going to be mighty big.

"Fund investors are probably going to pay even more than the near-record amount they paid last year," says Tom Roseen, senior fund analyst at Lipper. Last year's tax bill, which was the largest since 2000, came to a whopping $23.8 billion.

At the T. Rowe Price funds, for example, the average capital gains distribution will jump more than 40%, from 3.7% of net asset value to 5.3%. Says Sam Beardsley, director of investment tax for the fund group, "That level is still below the 6.1% distribution in 2000, but it's getting pretty darn close."

Remember, even if you don't sell your mutual fund shares, you're on the hook if the manager sells investments in the fund at a profit, unless you own the fund shares in a tax-deferred account such as a 401(k).

Compared with 2000, though, investors have the benefit of today's lower tax rates. Qualified stock dividends and long-term capital gains are typically taxed at a 15% rate. But interest income and short-term gains will be levied at federal income tax rates, which can run as high as 35%.

One reason for the escalating tax bill is this year's wild market. As stocks plunged over fears of a subprime meltdown, and investors began to shift from small stocks and value fare toward large-cap growth stocks, fund managers traded more frequently.

In previous years fund groups have been able to minimize the effect of these distributions with an accounting maneuver - essentially funds could offset their gains with losses incurred during the 2000-2002 bear market.

But by last year most of those losses were used up. And today, "the tax losses have pretty much evaporated," says Duncan Richardson, chief equity investment officer at Eaton Vance.

Still, not every fund is going to stick you with a giant tax bill. The distribution you receive will depend on the type of fund you own and the manager's investing style. By and large, funds that trade more frequently tend to incur bigger gains than those that follow a buy-and-hold strategy.

This year, however, some funds that have long avoided taxable distributions have run out of room to maneuver.

The Muhlenkamp (MUHLX (Charts) fund, for one, will make a taxable distribution equal to 10% of net asset value this year, according to manager Ron Muhlenkamp, who typically tries minimize the tax bite on investors. It will the first such payout since 2000.

You are likely to find the heftiest taxable distributions among the categories that have delivered the best returns in recent years, such as value and small cap funds.

For example, Vanguard estimates that Windsor II (VWNFX (Charts), a large value fund, will pay out a $3.57 a share. At its current share price of $37.14, that distribution would amount to 10% of net asset value. That's up from 6.5% last year.

Janus Venture (JAVTX (Charts), a small growth fund, is expected pay out total capital gains per share of $11.44, or 14.6% of net asset value vs. 12% last year.

You can also expect a larger tax bill if you own a foreign stock fund. After a five-year bull run, says Morningstar analyst Bill Rocco, most overseas funds have significant potential capital gains exposure.

American Fund Small Cap World expects to make a capital gains distribution of 9% to 11% of net asset value. And T. Rowe Price European Stock (PRESX (Charts) is on track to report taxable gains of 13.1%.

Some of the biggest distributions may not be the result of performance but changes in fund management.

At American Century Ultra (TWCUX (Charts), where new manager Tom Telford has been shuffling the portfolio, the fund is on track to pay $6.83 a share in long-term capital gains, or 21% of net asset value. American Century spokesman Brian Spano points out that Ultra, which long lagged its peers, has zoomed 20.2% so far this year, a return that ranks in the top 25% of its large-growth category.

If you are seeking to invest new money in a fund before the end of the year, be sure to wait until after it makes its taxable distribution - you can check the schedule by calling the company or looking at the Web site. Otherwise, you may end up paying taxes on gains you never received.

You can also keep your future tax bill low by choosing funds that are highly tax efficient for your taxable accounts, says Joel Dickson, a tax specialist at Vanguard. Some good choices include index funds and tax-managed funds, which are designed to reduce taxable distributions.