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To avoid tax hit, read fine print before buying mutual funds late in year
Mistakes occur most often when people rush into a surging market.
NEW YORK -- Investors itching to take part in the stock market's recent run-up should watch out when investing in a mutual fund that they aren't also buying into a tax liability now that 2006 has entered its final months.
A seemingly good investment could leave investors with lower-than-expected returns initially and a hefty tax bill if they fail to pay attention to the date on which a mutual fund makes payouts to shareholders.
Wilma Hayes, a financial adviser at H&R Block Inc., said most investors should avoid putting money into a fund before its distribution date has passed.
"If you go into it before that date, you're literally purchasing yourself a tax bill."
Mutual funds, which are required to pass their capital gains onto shareholders, generally do this near the end of the year. The payouts not only leave investors facing capital-gains taxes but also reduce the value of the fund by the amount of the payout. So these investors are paying for a fund whose net asset value will soon decline.
"They're actually going to get some of the money back that they put in," said Jeff Adelstone, an accountant in Tucson, Ariz., adding that the investors would then be taxed on that money.
He advises clients to try to hold many investments for at least a year and a day in order to be taxed at a long-term capital gain rate of 15 percent, rather than simply a general income tax rate, which can be as high as 35 percent.
Investors simply need to check with a mutual fund to see whether it plans to make a capital gains or dividend payment and, if so, when. Often, funds post their distribution date on their Web sites around this time of year.
Hayes said while most investors generally avoid getting into a fund shortly before a distribution, mistakes occur most often when people rush into a surging market. To make matters worse from a tax perspective, a robust market often translates to higher distributions from mutual funds.
"The financial markets are emotional and people don't plan ahead. When we really see it is when you have a rally like you have in the market and people want to get in on gains. They just don't realize that this phenomenon exists," she said.
An impending distribution does not necessarily bar investors from buying mutual funds. Often investors can employ a tax-deferred retirement account such a 401(k) to their advantage, Hayes notes.
"If they have a retirement account and they find that they just can't control themselves and they just want to get in on that green they should buy the fund in that retirement account," Hayes said.
Catherine Gordon, head of the financial planning division at The Vanguard Group contends that investors might only want to delay their investment if the realized gains in a fund's portfolio make up a sizable portion of the fund's net asset value or if a large dividend payment is going to be made. She also notes that the investors who should be most concerned about the tax effects are those making large, lump-sum investments; those making fairly small investments likely have less to worry about and should probably keep making contributions.
Gordon said Vanguard encourages investors not to sell fund shares solely for tax purposes and points out that investors are generally better off paying capital gains taxes on a distribution rather than the capital gains taxes they would have to pay if they were to sell the shares. That's because the long-term capital gains would likely be larger than the gains realized from a single distribution.
Keith Lawson, senior counsel for tax law at the Investment Company Institute, a mutual fund industry group, said it depends on the needs of the individual investor but that in many cases it can still make sense to buy a fund in advance of the distribution date.
"If you have a fairly disciplined savings practice you may not want to disrupt that just for distributions. If you stop saving that's the worst thing you can do," he said.
He also notes that in some cases the returns investors can receive on an investment, even one held a relatively short time, can make incurring the capital gains taxes worthwhile.
In some cases, funds that incurred capital losses in previous years can apply part of those losses to reduce the total amount of capital gains that must be paid out in a subsequent year. Therefore investors would of course pay less in taxes because the distribution is lower than it would otherwise be.
Individual investors can do the same thing. If they incur capital losses when they sell part of one fund, they can apply those losses to the capital gains realized in another fund to cut their tax bill.
Over all, experts recommend investors continue to put away money and remain aware of a fund's distribution plans when making investment decisions.