The next month or so could be a dangerous time to invest in mutual funds. What’s the problem? The risk that stock prices will fall? The chance of a sharp decline in the bond market?
Not at all. The danger is that you might buy shares of a fund that is about to distribute profits to its shareholders. If you do buy such a fund, you could end up paying taxes on profits that someone else earned.
Ridiculous? Absolutely. But that’s beside the point. The fact remains that some investors will pay capital gains taxes for 2000 — on gains that they didn’t receive!
A Crash Course
To avoid joining that unlucky group, you need to understand how taxes are attributed to fund shareholders. Let’s say you invest in a fund trading at $12 a share just before it makes its annual capital gains distribution to shareholders. Assume that the distribution equals $1. When the distribution is made, the share price will decline from $12 to $11, and you will receive a $1 payment along with the other shareholders.
Here’s the bad news: You’ll owe taxes on that $1 — even though it represents part of your original investment.
Amazingly, some brokers will try to get you to buy a fund just before a distribution occurs. They might argue that such a purchase offers an easy way to pick up a quick dividend. In fact, you’re just picking up a quick tax bill.
How to Avoid a Costly Mistake
How can you avoid making that mistake? Easy: Before you invest in a fund’s shares, call the sponsor and find out when it plans to make its next capital gains distribution. Also find the date of record for the distribution. Once that date is past, you can buy shares without worrying that you’ll be liable for taxes on the distribution.
How important is it to check on this before you invest? The answer depends upon the size of the capital gains distribution coming up.
If a fund has had a terrific year, it is likely to make a fat capital gains distribution at year-end. For example, Fidelity Aggressive Growth gained 103% in 1999, and paid capital gains and income distributions of $3.92 per share on December 17. An investor who parked $10,000 in the fund just before that date would have received a distribution of about $603.
Unfortunately, such funds are the very ones that are most likely to attract new investors — who often arrive just in time for taxable distribution.
That doesn’t mean you’re safe with a fund that has had a mediocre year. Many funds carry hefty unrealized capital gains from past years. Those gains are the paper profits on securities that the funds’ managers haven’t yet sold.
When they do realize those profits by selling the stocks, the funds will make sizable distributions that could catch new investors unaware. You should ask about such unrealized capital gains before you invest in a fund. If they amount to more than 25% of the fund’s total net asset value, you may want to look elsewhere. Be especially wary of technology funds that posted huge gains in 1999.
Why All the Fuss?
Why all this fuss about a few bucks in taxes? The fact is, taxes can have a huge impact on fund returns. According to one study by Stanford University researchers, taxes reduce the long-term returns of many mutual funds by more than half.
If that doesn’t get you motivated to check out a fund’s potential tax liability before you invest, than think about this: It’s bad enough paying taxes on your own profits. Wouldn’t you feel kind of stupid paying taxes on somebody else’s?
