The Fund Christmas Present You Don’t Want

December 2, 2005

Sure April 15th gets most of the glory, but in the world of mutual funds, tax time is really in December. Why? Because that’s when stock funds typically distribute taxable gains to fund shareholders. 

Throughout the year, fund managers sell stocks at a profit. Some companies that mutual funds own pay dividends. Each year – usually in December - a fund has to distribute these realized gains and incomes to fund shareholders or face tax penalties. 

Fund investors will either get cash from the fund company reflecting these gains, or the fund company will re-invest each shareholder’s distribution money by buying more shares of the fund, depending on the option the investor has chosen (the default tends to be reinvested – which fund companies love). Either way, it is up to the fund shareholder to pay taxes on the gain.

While you don’t want the tax tail wagging the investing dog (putting tax issues ahead of sensible investment decisions), tax issues are extremely important. Remember – it’s  after tax returns that matter. 

December’s mid-month portfolio review will get into the specifics of which funds in our model portfolios you need to look out for this tax season, and why (at that time we’ll also provide a complete list of capital gains and dividend info for every fund in our model portfolios, as well as short term redemption fee information for each fund).

The short story is that this year there are no ticking tax time bombs you need to act on right away  to avoid. That said, any new money going into the funds in our model portfolio should consider waiting until aat least the day after the record date. Ignore this advice in tax-deferred accounts like IRAs. 

We tend to own tax-efficient funds (more on this in our tips below) so this time of year has not been too painful for Powerfund Portfolio followers. Generally investors want to avoid dividends of more than a few percent of current fund price or NAV (see our chart) – a $1 per share dividend is significant on a $10 per share fund, not a $50 per share fund. A few of our funds have big distributions this year (generally funds that made big investment gains), but most paid them out a few months ago. 

Until our mid month portfolio commentary in a couple of weeks, please enjoy this list of our best year end fund tax tips and tricks.

Powerfund Portfolios Mutual Fund Tax Tips:

1) Tax distribution issues only apply to investors who own funds in taxable accounts. If all of your fund holdings are in your 401(k) or IRA, congratulations - you can stop reading this article right now. Along the same line, you should try to put your most tax inefficient funds in your tax deferred accounts. Tax inefficient funds are the ones that often make large taxable distributions, including funds with high portfolio turnover, funds that own junk bonds, REITs, emerging market bonds, and those using option strategies.

2) Shareholders do not make more money from these year end capital gain distributions because the fund NAV (or net asset value) falls to reflect the dividend – all they get is a tax liability – often somebody else’s tax liability if you buy just before the distribution. 

3) If you have big loss carry-forwards from buying hot funds that had five star ratings in 2000 and sold them at a loss in 2002, you can largely ignore these current distributions as you can use your past losses to offset any current distributed gains (but not ordinary income distributions from bond funds).

4) There is very little you can do to avoid taxable distributions if you already own a fund in a taxable account, and you have owned the fund for less than a year (if the fund is at a gain). If you sell, you could incur a short term redemption fee. Worse, you would have to realize any gain you have in the fund at the short term capital gain tax rates, which is taxed like ordinary income. This is often worse than the distribution you are trying to avoid – which may include some long term capital gains, taxed at a lower rate. 

5) Even if you get hit with a big year end dividend, you can sell the fund shortly thereafter as the fund NAV will have fallen to reflect the dividend distribution. You will then have fewer gains (maybe even a loss) on the sale, wiping out the taxable gain in the distribution.

6) Out of favor funds can be very tax favorable going forward. We generally buy funds that are out of favor. Out of favor funds usually have lost investors money before we buy them (which is generally why they are out of favor). Oftentimes these funds have big tax losses on the books because investors piled in at the top when the funds were hot and sold a few years later. This means that even though some of our funds have posted big gains this year, Powerfund Portfolio investors may not even get a big taxable distribution. Japan funds are a good example of this phenomena. There you have it – contrarian fund investing not only works, but it means you benefit tax wise from past investors’ mistakes.

7) While there is little you can do if you already own the fund, you should avoid buying a new stake in a fund if it is about to issue a big dividend distribution. If you are considering buying a new fund holding, give the fund company a call or check their website. They’ll often be able to tell you if a big distribution is imminent. 

8) The Powerfund Portfolios favor funds with low portfolio turnover and little hot money (fund investors moving in and out, forcing the manager to buy and sell stocks to match the flows). This means sudden, giant taxable gains are less likely – but not impossible. 

9) Bond funds pose less of a year-end tax danger than stock funds. Bond funds often make dividend payments regularly (usually quarterly but sometimes monthly) in the form of ordinary income from the bonds in the portfolio during the year. Bond funds generally don’t save up big distributions for year end, and bond funds rarely have big gains to distribute each year because bonds themselves rarely make massive gains or losses during the year. However, bond income is fully taxable as ordinary income. Stock fund income from long term capital gains and dividends can be more tax favorable.

10) If you own a fund that has done very well, the taxable distributions may be lower than normal because whatever gains were realized by the fund get passed on to an ever increasing shareholder base – new investors  water down the distributions and take on some of your tax liability. Often funds we own go on to bring in large amounts of new shareholder money because of the good performance. 

11) ETFs generally don’t make big taxable distributions at year end because of their complex structure. What little dividends they pay are often largely long term gains or low tax dividend income and distributed quarterly. ETFs don’t require much thought at year end

12) Index funds don’t usually make big taxable distributions because of the low turnover. 

13) If you recently bought a fund that has no redemption fee or other penalties for sale and a) the fund is flat or at a loss since you bought it, and b) it is going to pay a big taxable gain, you should consider selling the fund and avoiding the tax hit. 

14) This one’s a little tricky, but a good tip: You can sell a fund and realize a tax loss, and buy a very similar fund if you want exposure to the same area and not worry about a so-called ‘wash sale violation’. The IRS says that investors normally can’t sell an investment to realize a loss and buy it back without waiting 30 days, because they consider it a move to generate a loss. You can, however, sell one emerging market fund and buy another very similar fund (or an ETF) and avoid a capital gains distribution and/or generate a tax loss.