Thursday, October 31, 2013

The horror of mutual fund taxes

Another successful Halloween: No soap on your windows, no mailboxes blown up, no one hacked to death in the shower. You're happy, until you reach into the mailbox. And then: The horror.

It's a notice from your mutual fund company telling you about your estimated capital gains distribution. That's right: Along with all those big investment gains this year comes a bigger tax bill. But you have plenty of ways to reduce your fund taxes, most of which do not involve silver bullets, garlic or splattered brains.
Mutual funds buy and sell securities all year, and when they have more gains than losses, they pass those on to you, around this time of year. Gains are good. Unfortunately, you owe taxes on those gains.
Suppose, for example, the entirely fictional Miskatonic River Fund gave you a long-term capital gains distribution of $666. You'd owe 15% tax on your gain, or $99.90. (If you're in the highest tax bracket — 39.6% — you'll owe 20% on your capital gains. You'll also owe an additional 3.8% Medicare tax, which kicks in at $250,000 in modified adjusted gross income for joint filers, and $200,000 single filers.)

Don't buy a mutual fund near the dividend date," says Don Zidik, director of individual trust and estate practice at Braver PC, in Needham, Mass. "You'll end up being taxed for income and gains earned over the full year." Basically, you'll be buying a tax bill when you buy fund shares.

Incidentally, when the fund pays out the distribution, its share price drops by that amount. So you're not getting anything extra when you get the distribution. It's already factored into the share price.

Even more horrifying than long-term gains distributions are short-term gains distributions, which are taxed at your regular income tax rate. And, while most dividend distributions qualify for taxation at long-term capital gains rates, some — such as most from real estate funds — don't.

Most fund companies provide an estimate of their capital gains and income distributions.! Fidelity, for example, estimated that Contrafund, based on its Sept. 30 record, would distribute 18 cents per share in short-term capital gains, $5.765 per share in long-term capital gains, and nothing in income.

Over time, taxable distributions reduce your returns. Consider Contrafund, which has a sterling 10-year record. It's up 10.29% a year the past decade, meaning the fund has turned a $10,000 investment into $26,629. Assuming maximum federal taxes, however, the fund is up 9.8% a year, turning $10,000 into $25,470 — a $1,159 difference.

What can you do to reduce your taxes? One solution is to switch to index funds. Funds that simply track an index, rather than trade stocks actively, typically have lower capital gains distributions. For example, the Vanguard 500 Index fund, which follows the Standard and Poor's 500-stock index, typically pays nothing in capital gains distributions. The fund earned an average 7.45% a year before taxes the past 10 years, and 7.09% after distributions. (The fund does pay out dividend distributions.)

You might also consider tax-managed funds, which try to offset capital gains with capital losses, minimizing distributions. Vanguard Tax-Managed Capital Appreciation fund (ticker: VTCLX) has gained an average 7.89% after distributions the past decade, according to Morningstar, the mutual fund trackers.

An obvious solution would be to put more money into tax-deferred retirement plans, such as individual retirement accounts or 401(k) plans. You wouldn't pay taxes on distributions until you start to withdraw funds at retirement. And if you invest in a Roth IRA, you wouldn't pay taxes on gains and distributions at all, assuming you followed the rules for withdrawal at retirement.

But putting stock-fund shares into an IRA to avoid taxable distributions might be creating a bigger tax bill down the road. When you invest in a traditional IRA or a 401(k) plan, you dodge taxes on distributions or gains in the year they're paid out. But when you withd! raw from ! one of these plans, your entire withdrawal is taxable income. And typically, that's at a higher rate than you'd pay on long-term capital gains — which is the rate you'd pay if you were in a taxable account.

Finally, if your distribution is large enough, you might consider harvesting losses, a polite term for selling fund shares that have performed hideously. You can use long-term losses to offset an unlimited amount of long-term gains. If you have more losses than gains, you can deduct up to $3,000 of those losses from your income. And if you still have losses left over, you can carry those over into the next tax year.

Sending your losing fund to Hades is always a good idea, especially at tax time. But your primary purpose for selling any fund should be performance — not taxes. As horrifying as taxes are, they're a secondary consideration to how your fund fits in your portfolio.

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