Bad Timing: Get Ready for Higher Taxes on Your Investments

Nov. 18, 2008 — -- 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.

Types of mutual funds particularly susceptible to large capital gains distributions in the face of huge 2008 losses include those specializing in emerging markets, energy and natural resources stocks. Each of these fund categories posted huge returns for investors over a few years before diving in 2008.

This year, they've been selling stocks that provided outstanding profits in 2006 and 2007, triggering a tax bill for investors despite the declines this year.

For example, the Matthews China Fund is down more than 50 percent this year after posting a 65 percent return in 2006 and a 70 percent increase in 2007. On Friday, it announced a distribution of long-term capital gains amounting to $6 a share on a fund trading for around $18 a share.

That means if you owns 100 shares of that fund, you'll be paying tax on a $600 capital gain for an investment worth about $1,800. If you bought those shares in 2005 and shared in the terrific returns of the next two years, then you might not be too upset.

However, if you bought into the fund at the start of this year and watched your investment lose more than half its value, then you will be quite upset.

The Matthews China Fund is not the only one. Other funds due to pay out large capital gains to shareholders after posting huge losses this year include the Dreyfus Premier Emerging Markets Fund, U.S. Global Resources Fund and many others.

What's an investor to do?

On the front end, you can avoid this problem by investing through a tax-advantaged account like an IRA or by investing in a comparable exchange-traded fund rather than a mutual fund.

Because of the way ETFs are bought and sold like individual stocks, in most cases, they do not pass along capital gains to individual investors.

If you do own mutual funds in a taxable account, check to find out if and when your funds might be paying a capital gains distribution. This information is posted on many fund company Web sites. Or you can call the fund family directly.

There are three key dates to look for:

Record date: All shareholders of record as of this date will receive the distribution.

Ex-dividend date: The date on which the distribution amount per share is deducted from the fund's net asset value, or share price. If you reinvest your dividends, then you will be receiving new shares equivalent to that amount.

For instance, if you own a fund that trades at $10 a share and that will distribute a $2 a share gain, then the share price on the ex-dividend date will drop to $8. But you will receive an additional $2 worth of shares. That means the total value of your investment is not affected by the capital gains payout.

Payable date: This is the date the fund actually pays out the distribution.

Calculate what the gain might mean for you in your tax bracket. Despite this year's declines, some fund holders still might be ahead on their original investment and may want to continue to hold the fund and avoid paying additional capital gains taxes if they sold the fund.

Others who bought into a fund recently and have experienced only losses, might want to consider selling their shares before the distribution is made to avoid the tax hit.

In either case, don't let taxes be the sole criteria for your investing decisions. Most important are long-term considerations.

Finally, if you're thinking about buying a particular fund in a taxable account, you might want to wait. Check to see if there will be a capital gains distribution coming soon from this particular fund. If there's one coming up soon, you might want to wait until after the distribution is made.

Even if you buy the fund just one day before the distribution is recorded, then you will be stuck with the tax consequences.

It doesn't matter what's fair or not. Those are the consequences.

This work is the opinion of the columnist and in no way reflects the opinion of ABC News.

David McPherson is founder and principal of Four Ponds Financial Planning in Falmouth, Mass. He previously worked as a financial writer and editor for The Providence Journal in Rhode Island. He is a member of the Garrett Planning Network, whose members provide financial advice to clients on an hourly, as-needed basis. Contact McPherson at david@fourpondsfinancial.com.