Tax Records of Mutual Funds

by Josh Charlson
We're not yet upon the season to be jolly, but it's already time to start thinking about taxes--yes, taxes--again.

Although most mutual-fund investors won't start examining their tax records until late winter and spring, autumn is the crucial season when investors can stumble into a number of tax traps, or when savvy ones will seize the opportunity to reduce next April's tax bite.

The single biggest tax issue for fund investors is the timing of year-end capital-gains and dividend distributions. Mutual funds are required to pay out all of their dividend income and net realized capital gains (that is, gains on securities traded within the portfolio) to shareholders before the end of their fiscal year. In periods of a rising stock market, as we've had in recent years, this practice can result in sizable distributions to shareholders and, consequently, an unpleasantly high tax bill.

Most funds make these distributions in December, but the actual date of payment--known as the "record date" or "ex-dividend date"--can vary depending on how they define their fiscal calendar. And don't assume that because one fund in a company's roster pays out at the beginning of December, the rest do; record dates may well be spread out over the month.

The 1997 tax-law changes have made the process of determining tax liabilities more complicated than ever. Capital gains are now divided into short-term (less than 12 months), intermediate-term (12 to 18 months), and long-term (more than 18 months) holdings, each of which incurs a different tax rate. Dick Bellmer, a financial planner with Deerfield Financial Advisors in Indianapolis, says that many investors "better go talk to an accountant" this year. He believes that the biggest surprise may come from the intermediate-term category, taxed at a maximum of 28%, because many funds will unlock such gains through their trading activities.

The traps posed by distributions arise when investors engage in another common year-end activity, reassessing their mutual fund portfolios. Most critically, you do not want to purchase a new fund just before it is set to pay out a substantial distribution (or even a small one). The reason for this is that although the value of your actual holdings in the fund will remain the same, you will be forced to pay taxes on gains that you have not been around to enjoy.

Take a hypothetical example: You've just bought 500 shares of a fund with an NAV of $10.00 per share, and the next day it pays out a capital-gains distribution of $2.00, where all distributions are being reinvested. Although the NAV of the fund will now be reduced to $8.00, you still own the equivalent of $10 per share with your reinvested $2.00. However, you will need to pay taxes on those capital gains. Say half those gains are long-term (taxed at the new rate of 20%) and half are short-term (still at 28% for middle-income taxpayers), then on your 500 shares you will have to pay $240 in taxes:

Out of your initial investment of $5,000 you are left with $4,760, meaning that you have taken a 4.8% loss just for the privilege of buying into the fund. And for shareholders taxed at a higher marginal tax rate than 28% (it can go as high as 39.6%), the impact will be greater on income and short-term capital-gains distributions.

On the flip side of the coin, it's usually ill-advised to sell shares in a fund after the ex-dividend date. It would never be a good idea to sell an otherwise satisfactory fund just to avoid paying taxes, but if you already have plans to get out of a fund--perhaps to meet cash needs or because a fund has changed its investment strategy--then it makes sense to redeem your shares before the record date and avoid forking over unnecessary taxes. Selling before the ex-dividend date will cause NAV gains on a long-term holding (one held longer than 18 months) to be realized at the 20% rate, but if you wait until after the ex-dividend date some percentage of those gains will be translated into a mix of dividends and short-term gains, which are taxed at your ordinary income-tax rate.

Bellmer points out one situation where it may make more sense to sell after the record date, however. If you are in a high income-tax bracket and are selling a short-term holding, waiting until after the record date will more than likely convert some of your short-term gains (taxed at the highest rate) to long-term distributions (capped at 20%), effectively lowering your tax liability.

The end of the year also presents the opportunity to lock in any capital losses, which can be deducted against capital gains and, even better, up to $3,000 of ordinary income. Although most owners of stock mutual funds should be up in 1997, certain areas of the market could be in the red. If you hold an emerging-markets or precious-metals fund, or if you bought a technology fund (or tech-laden one) late in the year, you should check whether any losses will be on the books.

Of course, we'd never recommend that you sell a fund just because it's had a bad year--don't email us if you sell your emerging-markets fund and Asia's up 50% next year--but if you have a fundamentally sound reason for bailing (you've decided that a different international fund better meets your needs, or you've recognized that your risk tolerance is lower than you thought) then you might as well benefit from the losses. And while you're at it, sell before the ex-dividend date. Nothing's more galling than getting socked with a tax bill on a fund that you've lost money in. Don't forget, too, if you're looking for a new international fund to shift your money into, wait until that fund has paid out its own year-end distributions.

How can you tell if and when a fund is going to make a large distribution? The best advice is to call up the fund and ask. The customer-service representative should be able to give you fairly accurate information, but you may not be able to get it until shortly before the record date. Some companies are more forthcoming: Vanguard is already posting estimated year-end distributions on its web site. Below are some specific funds that could make large distributions; keep in mind that these are only potential risks. Call the fund companies for more details.

Two caveats apply to everything written here. First, everyone's tax situation is different, so be sure to consult your tax advisor about the applicability of this advice to your personal circumstances. Second, don't let tax considerations take precedence over investment considerations. Avoiding a big distribution makes no sense if it means getting rid of a strong-performing fund. So by all means scrutinize your tax situation closely, but don't forget that it's how much you end up with at the end of the day that determines your ultimate success as an investor, not how much you save on taxes.


  1. This article makes the argument that a higher stock market will lead to higher capital gains distributions and higher tax liabilities for investors. Why might this be so? Is there a way in which mutual funds can avoid creating this tax liability for their investors?
  2. The article warns against buying a new fund just before a large distribution because it may create a tax liability on non-existent gains. Explain the argument.
  3. The article also warns against selling after the ex-distribution data. Why?