November 16, 2011 / 9:11 PM / 6 years ago

How to avoid tax traps and find havens in fund distribution

NEW YORK, Nov 16 (Reuters) - In a volatile year for the stock market like this one, it’s worth paying attention to mutual funds’ potential tax situations before they make distributions. If you buy into a fund with a hefty distribution slated, you’ll end up paying the price. Conversely, if you invest in a fund with a lot of capital losses built up, you’ve just found yourself a nice tax haven.

Investors often don’t think much about distributions, but at this time of year they should. By law, all mutual funds must distribute any taxable gains realized during the year from selling appreciated stocks. Most do so in December, before the tax year ends.

Investors who buy into a fund just before its distribution will owe tax on the entire payout, even if they held the fund for just a few days.

“It is prudent for an investor to look at the distribution schedule and try to see what it’s posted historically. You may want to work around some of those dates from a tax perspective,” says Brittney Saks, a personal financial services partner at PricewaterhouseCoopersin Chicago.

What might funds’ tax situations look like this year? Vanguard and Longleaf have recently released numbers that look pretty tame. For those that haven’t released data yet, a good place to start is the “potential capital gains exposure” statistic on Morningstar. It quantifies a fund’s gains or losses that have not yet been distributed to shareholders or taxed, as a percentage of assets, based on estimates of both returns and assets. While it’s an estimate, it’s a pretty good indicator of those future capital gains distributions, especially when looked at in conjunction with the fund’s turnover ratio.

“It should be a fairly mild tax season barring a few quirks,” says Russ Kinnel, Morningstar’s director of fund research. “It’s been a kind of unusual year because it’s flat year-to-date, but with a lot of drama in the market with the August-September sell-off and the October rally. The numbers will say something about how closely the funds were watching their tax positions.”

From a tax perspective, expect bargains in foreign-stock funds, Kinnel says, (Europe, anyone?). But year-end investments in small-cap, mid-cap and gold funds could be more tricky. The impact of any tax hit will be less for funds with rising assets, and greater for any that has seen outflows, because there are less assets for any gains to be distributed among.

Those with relatively high potential capital gains exposure by October 31, according to Morningstar’s calculations, include Baron Asset Retail , a mid-cap growth fund, T Rowe Price New Horizons , a small-cap growth fund, and T Rowe Price Media & Telecommunications .

Those that may be tax havens include Vanguard European Stock Index , a tax-efficient fund for those with the stomach for betting on Europe; Bogle Small Cap Growth , a small-cap growth fund; and Litman Gregory Masters Value , which boasts an all-star manager lineup and could be working tax-free for some time.

In some cases, the tax impact is enormous. Take that Vanguard European Stock fund, where it’s possible to see more details about its tax situation because Vanguard discloses more details than most fund companies do. It’s got $19.33 per share in realized capital losses (or nearly 38 percent of the fund’s net asset value) at the end of September, and $32.70 per share (or 64 percent of NAV) in unrealized capital losses. That’s the silver lining of the ongoing debt debacle in Europe for those with the stomach to play it.

Obviously you won’t want to make investment decisions solely based on taxes. How much difference these mutual-fund tax issues make to you depends on your own tax situation.

If you’ve still got a large tax loss carryforward (from taking capital losses throughout your portfolio since the 2008 financial crisis), then you may be able to offset any capital gains distributions with those stockpiled losses. In that case, the funds’ tax situations are a nonissue. However, if your own stockpile of tax loss carryforwards has dwindled, and you haven’t taken losses this year, it’s worth paying attention to these coming distributions when thinking about whether to buy or sell a fund before year-end .


The author is a Reuters contributor. The opinions expressed are her own.

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