Fri, November 18, 2011
As the end of the year approaches, mutual fund owners may benefit from examining their holdings and considering some timely sales.
By law, at the end of each year a mutual fund is required to distribute most of the net capital gains realized during the year to shareholders. If a fund has experienced short-term capital gains, these will be distributed and taxed to fund owners as ordinary income. This is especially unpleasant for Massachusetts taxpayers, who pay a short-term capital gain rate of 12% on top of Federal taxes. Long-term gains have the benefit of capital gains taxation at a maximum Federal rate of 15%.
If you own a mutual fund in a taxable (vs. a retirement) account, these distributions can require some planning. Suppose that you’re thinking about selling a mutual fund early next year. If the fund makes a short-term capital gains distribution this year, you’d owe ordinary income tax on the distribution and the price of the fund would adjust downward on the day of the distribution. If you’d sold the mutual fund early enough to avoid receiving the distribution, you might have been able to realize only long-term capital gains. So it makes sense to examine your holdings now to see if there are funds that you might want to sell. Knowing ahead of time whether a fund is going to make a distribution can be difficult, but you can look at Morningstar.com to see whether a fund appears to have significant capital gains exposure, which could be a sign of a looming tax liability.
Something else to keep in mind: if you buy a mutual fund near the end of the year and the fund makes a distribution, you must pay taxes on that income even if you reinvest the distribution in the fund. Buying mutual funds shares from now through the end of the year can trigger a taxable event that you might not want. If you really want to buy a particular fund, look up its distribution date history and wait until the date has passed before making your purchase.
Purchases and sales shouldn’t be made exclusively on the basis of tax considerations, but keep tax consequences in mind in order to maximize your after-tax investment returns.