Ask MAX: Avoid Buying Funds In December?

December 7, 2004

Dear MAX,

I was told by a friend that I shouldn’t buy mutual funds at the end of the year because I can be hit with additional fees. Is this true?


Dear Martha,

Your friend was referring to capital gain distributions, which are actually a different animal than ordinary mutual fund expenses (like management fees, expense ratios, or 12b-1’s). But while your friend is right (cap gains do pose a potential risk to investors who purchase a fund near the end of the year), the distribution trap is a hazard that can usually be avoided with a simple phone call.

Capital gains and dividends are taxed the same, whether they are generated by stocks owned by your mutual fund, or by those in your individual portfolio. If you have ever sold an individual stock for a profit, you know that the profit is called a capital gain, and you had to pay a tax on it.

The same goes for mutual fund investors, but the process is a little bit different. A fund manager might make hundreds of trades a year, some for a profit, and some for a loss. If the manager’s trading creates a net profit that isn’t offset by the previous year’s losses, those profits are distributed to fund shareholders, usually once a year, either in the form of cash or by re-investment into the fund. Most mutual funds issue these capital gains distributions in December.

Fund shareholders are then liable for taxes on those capital gains, and each fund shareholder owes the same amount per share – no matter what time of year they invested in the fund. A guy who invested in February owes the same amount per share as a gal who bought the fund the day before the distribution was announced.

So, you’re thinking, that doesn’t sound bad at all: I invest in November, and in December the fund company sends me a check, a portion of which I owe in taxes. I still end up with free money, right? Wrong. The thing is, when a fund issues a distribution to its shareholders, the value of the fund drops by the exact amount of the distribution. If a fund issues a distribution of a buck a share, the fund’s NAV will drop by a dollar a share on the day the distribution is made. Shareholders gain absolutely nothing but a tax liability when capital gains are distributed.

The guy who invested back in February doesn’t mind this liability too much, because he’s been watching the value of his mutual fund investment rise for most of the year. But if you had been the gal who invested in the fund in December, you’d still owe as much per share as Mr. February does, even though you had missed out on most of the fund’s gains. Yes, it seems awfully unfair, but that’s the way the tax law is written.

The good news is, now that you are aware of the capital gains trap, it is very easy to avoid. If you are buying the fund through an IRA or 401(k) account, you’re in the clear right off the bat because you aren’t liable for taxable gains generated in these tax-deferred accounts. If you are investing in a fund through a taxable account, call up the fund company or check their web site and ask them to tell you the dates and amounts of any upcoming distributions. This is worth doing any time of the year, not just in December, because while most fund companies distribute taxable gains just before the ball drops in Times Square, they can (and some do) make their distributions at other times of year as well.

If the phone rep tells you that a sizable distribution is coming up, just wait until the day after what is know as the “record date” (the date you have to be a shareholder in the fund in order to get the distribution) to invest. You’ll be starting fresh, with a clean capital gains slate, and it’ll be the other guy who gets stuck with the unfair tax bill.

Thanks for the question.


Want to ask MAX a question of your own? Send him an email by clicking here. Please include your name and where you live.