Buying Mutual Funds at This Time of Year Can Be Taxing

By John Waggoner

You're used to getting ominous packages in the mail from your mutual fund company. Dense prospectuses with tortured prose. College savings accounts hemorrhaging red ink. Statements of slaughtered retirement accounts, printed on special paper made from crushed dreams.

Soon, funds will be delivering one more package to you: statements of year-end capital gains distributions. And for the vast majority of investors, the news will be ... surprisingly good, actually.

Thanks to the massive losses from 2008, many funds won't be paying any capital gains distributions. But if you're thinking of buying a fund this year -- particularly if the fund has hot performance -- check to make sure you're not buying a bigger tax bill at the same time.

Mutual funds buy and sell stocks and bonds all year long. But the funds don't pay taxes on their portfolios' income or capital gains. Instead, they pass the tax liability on to you.

Funds normally tally their capital gains this time of year, and pay them in December or late November. For example, let's consider the illustrative yet fictional Bullmoose fund, which sells for $10 per share. You own 2,500 shares, or $25,000 of the fund.

The fund calculates its distribution and determines it must distribute:

*50 cents per share of long-term capital gains. Long-term gains are taxed at 15% for most people, and at 0% for those in the 15% tax bracket or lower. You'd get a distribution of $1,250, and owe $187.50 in taxes.

*30 cents per share of short-term gains. Short-term gains are taxed at the same rate as income. You'd get a $750 distribution, and owe $112.50 in taxes.

*10 cents per share of income from qualified dividends, which are dividends paid by most U.S. corporations. Qualified dividends are taxed at the same rate as long-term capital gains. You'd get a $250 distribution and owe $37.50.

Your tax bill from the fund: $337.50. How could you make this worse? By investing in the fund just before the fund pays it out. You'll owe taxes on gains that you never enjoyed.

Bear in mind that the fund's distribution is not just an extra goodie doled out for your enjoyment. On the day the fund pays its distribution, its share price drops by the amount of the distribution. If you see a sudden, unexplained drop in your fund's share price between now and the end of the year, this may be the reason.

In this example, the Bullmoose fund's share price would drop by 90 cents per share, to $9.10. (In the real world, the fund's share price would also rise or fall according to how its portfolio fared that day. But we'll just say, for the sake of example, that the Bullmoose fund's assets were unchanged by that day's market action.)

In this example, then, you'd have 2,500 shares worth $9.10 each, or $22,750, and a distribution of $2,250. Most people elect to reinvest their distribution in additional shares.

Funds can, if they choose, manage their portfolios to minimize taxable distributions. They can offset big gains by selling losing positions. (Unfortunately, they can't distribute capital losses.)

Many of the largest fund companies are distributing little in capital gains, if at all.

The American Funds Group, for example, says it expects to pay no -- or nominal -- capital gains distributions this year. No capital gains from Fidelity Contrafund, either: just an 11-cents-per-share dividend distribution. None of the Columbia stock funds plan a distribution this year. Vanguard hasn't announced its estimated distributions yet, although the company's funds tend to be very tax-conscious.

A few hot funds, however, will pay out capital gains. Fidelity Select Gold, up 121% the past 12 months, says it will distribute 67 cents per share in short-term gains. T. Rowe Price Global Large-Cap stock, up 40.7% this year, estimates a $1.18 short-term gains distribution. And the Direxion Monthly Commodity Bull 2x fund, up 59% this year, will hand out a $2.21 per share capital gains payout.

If you have invested in a company 401(k) plan or any other tax-deferred retirement plan, of course, you don't have to worry about year-end distributions.

If you're investing in a taxable account, however, check with the fund company to see if it plans any distributions before you buy. If you're particularly tax-averse, consider:

*Buying tax-managed funds, which aim to keep distributions at a minimum. The top-performing tax-managed funds are in the box. Index funds also tend to have very low capital gains payouts.

*Selling a losing fund. You can use capital losses to offset any amount of capital gains. If you still have losses left over, you can deduct up to $3,000 on your 2009 taxes. And you can carry any remaining losses to the 2010 tax year.

Fortunately, there won't be too many hideous tax surprises in your mail this year. But stay tuned for Capital Gains 2010 -- the sequel.

John Waggoner's column appears Fridays. E-mail: jwaggoner@usatoday.com. Follow him at www.twitter.com/jwaggoner (c) Copyright 2009 USA TODAY, a division of Gannett Co. Inc.

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