How would you like to pay taxes on an investment that has lost more than 40 percent this year?
Sounds unfair, yet that's exactly the situation facing many mutual fund owners as we wind down one of the worst years ever for investors.
Scores of mutual funds that posted big returns in past years but are down 40 percent or more this year are scheduled over the next few weeks to pay accumulated capital gains to their shareholders, triggering ugly tax consequences for them.
This is true whether you bought the fund three years ago and reaped the rewards then or you invested at some point this year and have experienced only losses.
The combination of mutual fund tax laws, recent market trends and panicked shareholders produced this investing insult. In some cases, investors will be able to sidestep the mess. Others may not. The key thing is for them to know what's going on and when.
The first thing to know is that we're only talking about mutual funds held in a taxable account. Mutual funds you own in any type of tax-advantaged account such as an IRA, a 401(k) or even a 529 college savings plan are not exposed to this problem. Owners of these kinds of accounts need not worry.
Second, it's difficult to offer blanket advice to every investor holding mutual fund shares in a taxable account. The proper response will vary by situation. I can only recommend that investors be aware.
By law, mutual funds must pass on to investors each tax year any capital gains they realize through their buying and selling of securities. This distribution of gains -- or the profits realized by the fund -- takes place late in the year, typically in late November or early December.
The individual investor is then responsible for paying taxes on that gain paid out by the fund, even if they have not sold the mutual fund in question. You're going to owe tax on your share of the distributed gain even if you just bought the fund and did not benefit from the gain.
For investments held for more than one year, the capital gains tax rate currently is 15 percent for those in the 25-percent or higher tax bracket. For lower income investors in the 15- or 10-percent tax brackets, the capital gains tax rate this year is 0 percent, provided their gains don't push them above the 15-percent bracket.
What's happening this year that's likely to compound the misery of many investors is that many mutual funds have sold stocks they bought years earlier and on which they realized big gains despite the big declines in the market this year.
For example, if a mutual fund bought an energy stock back in 2003 and then sold it early this year, there's a good chance the fund realized a sizable profit. So even though the fund has dropped in 2008, it still realized a taxable gain on that energy stock and soon will be passing on that gain to the shareholders.
In many instances, there may have been a good reason for the fund manager to sell a particular stock. However, the market panic we've experienced over the past couple months has made the capital gains problem worse for mutual fund shareholders.
As investors have panicked and sold their mutual fund shares, fund managers have had to sell off stocks they wanted to keep, increasing the level of gains that will be passed on to the shareholders left behind.