Taxing Burden on Your Year-End Mutual Fund Statement?
Dec. 5, 2001 -- Losing money and owing money?
Many investors may find themselves in exactly that seemingly unfair situation as the year draws to an end. With the average stock mutual fund down a negative 22.2 percent year to date, investors could be facing losses and receiving distributed capital gains on which they'll have to pay taxes.
Because mutual funds are typically a long-term investment, investors erroneously believe they do not have to pay taxes until they sell their fund shares. Unfortunately, this is not the case. You can actually suffer a loss in your investment and owe capital gains taxes at the same time.
In the wake of significant market volatility this year, many fund managers have had to raise cash by selling their most liquid and often times best performing issues to cover substantial investor redemptions. When your fund manager's individual stock and bond sales lead to more profits than losses, the fund is required to "distribute" those excess gains to you thereby leaving you with a tax bill.
Tax Deferred vs. Taxable Accounts
If your fund is held within a tax-deferred account such as a 401(k) or an individual retirement account, or IRA, you will not owe any taxes until you withdraw your money. But, if you own a fund in a regular or taxable account, you generally have to pay at least 20 percent in taxes on the fund's realized gains.
Even if you do not take the distribution as cash and instead reinvest the dividends to buy more fund shares, the Internal Revenue Service will still come knocking.
Gains that are unrealized when the fund's securities appreciate but are not sold appear on paper only. They are not taxed until they are "realized" and distributed to you, the shareholder.
It is essential you know and understand a fund's record date before opening a new account. If you own shares on or before that date, you will receive the scheduled distribution.
For a new shareholder, this can be a less than favorable situation unless you enjoy paying someone else's taxes. More specifically, when purchasing shares prior to the record date, you will pay taxes on all capital gains incurred prior to your ownership, regardless of how long you have owned the fund.
Does this cloud have a silver lining?
Keep in mind that distributions are not necessarily a bad thing. Distributions can be a good sign that a fund has been successful in buying and selling stocks or bonds that have risen in value. However, the tax liability of distributions is there and can be hazardous to investors who have not prepared for this added expense.
Tips on What To Do
Avoid "buying the distribution" when you purchase shares of a fund. Don't pay other people's taxes. Call, log on to your fund's Web site, or speak to your financial advisor to determine the record date.
Look for stock funds with low turnover rates because they hold stocks longer and can be more tax-efficient.
To minimize current taxes on your mutual funds, invest through a tax-deferred account such as an IRA, SEP-IRA or other tax-qualified retirement plan. No taxes are due on any earnings until you withdraw the money. At the time of withdrawal, you will pay ordinary income taxes. However, because your earnings remain untouched in your account for an extended period of time, you will be able to generate a potentially greater investment return. Remember, earnings grow tax free in a Roth IRA.
Always make your investment decisions with taxable returns in mind, but do not let tax issues alone control your investing decisions.
This year underscores the importance of investing for the long-term. Keep contributing your money to your retirement fund.
Mellody Hobson, president of Ariel Capital Management in Chicago, is Good Morning America's personal finance expert. Click to visit her Web site Ariel Mutual Funds.com. Ariel associates Matthew Yale and Anne Roche contributed to this report.