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Fund investors: Don’t let Grinch leave unexpected tax bill


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Mutual funds must conform to U.S. tax law to maintain their status, making this is a tricky time of the year for fund investors holding their shares in taxable accounts (i.e. not in 401-K or IRA accounts).

A mutual fund buys and sells securities throughout the year. It will buy or sell for “fundamental” reasons, such as buying a stock with the belief it is “cheap” and likely to rise or selling a stock with limited upside potential.

A fund also will buy securities when investors give the fund cash when they purchase shares and sell securities to raise cash to payout departing investors.

Whenever a fund sells a security, if the sale price is different than what the fund paid for the security (i.e. the fund’s “cost basis”), the fund realizes a capital gain or loss. If the security was held more than a year, the gain or loss is considered “long-term.” Less than a year is considered “short-term.”

Funds are required to distribute realized capital gains and income to shareholders at least annually; many elect to do so at the end of the year. A fund will net its long-term gains vs. long-term losses. Similarly, short-term gains are netted against short-term losses. If there is a net long-term and/or short-term gain, those are distributed to shareholders. Net realized losses can be “carried forward” and used to offset gains in future years.

Most U.S. stock funds realized substantial net capital losses in 2008. Fortunately, funds were able to utilize these losses to offset gains in 2009 and beyond. The upshot is fund investors have generally enjoyed the best of both worlds since the bottom; strong performance, with little in the way of capital gain distributions.

Unfortunately, many funds have exhausted their loss carry forwards and again will be distributing realized capital gains to their shareholders.

A fund calculates its capital gains distribution by dividing the total dollar amount of net gain by the number of shares outstanding on the “record date.” For example, assume Fund A has $10 million of net long-term capital gains for 2013 and 1 million shares outstanding on its record date of Dec. 27, 2013. Thus, each share will receive a distribution of $10 of long-term capital gain (note the fund’s net asset value will immediately drop by the same amount).

A taxable shareholder will pay income tax on the number of shares she owns on Dec. 27 times $10. Here’s where it gets tricky. She will receive the same taxable distribution whether she has owned the shares one day or 10 years.

Most funds post distribution information on their websites, including estimated distribution amount(s) and the record date. Taxable shareholders should avoid buying shares of a fund in front of a distribution. As Morningstar’s Christine Benz says, “the last thing you want to do is buy into a fund and pay taxes on a distribution that you did not enjoy in any way, shape or form.”

Finally, taxable shareholders should consider a fund’s “tax efficiency.” Given similar performance, you’d much rather own shares in a fund that “buys and holds” securities and thus generates relatively little in realized gains versus an active trader that creates a boatload of short-term gains.

Don’t let the Grinch leave you an unexpected year-end lump of coal.

Mickey Kim is the chief operating officer and chief compliance officer for Columbus-based investment adviser Kirr Marbach & Co. He can be reached at 376-9444 or mickey@kirrmar.com.

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