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Mutual fund capital gains distributions created big tax pains for April 15, 2001
Large capital gain distributions at the end of last year give rise to tax planning headaches for mutual fund shareholders.
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The following is my attempt to explain what “embedded gains” in mutual funds are.
Many mutual fund shareholders received large capital gain distributions at year-end 2000 even though many of the funds showed minimal or negative returns. Trading during 2001 has been volatile and very active as both the Dow and NASDAQ have dropped significantly. Fund managers have sold stocks to try to better returns, and they must also sell stocks to meet demand for liquidation. With the market volatility and correction that continues, many managers feel it is time to realize capital gains acquired over the past several years when many companies produced annual returns of 30% and more.
Capital gains allocation
Mutual fund capital gains are allocated as follows. Assume that your mutual fund purchased America OnLine (AOL) in February 1996 at $3 per share. They sold AOL during the July correction to raise cash and to protect large gains in that particular stock. The sale price was $60 per share. The fund itself from date of purchase to date of sale actually realized a gain of $57 per share on that particular stock. However, you purchased the mutual fund in early June when AOL was trading at $55 per share and the mutual fund was already up considerably from the 1996 share price. Your real gain in AOL is only $2 per share, but you will pay capital gains on the full $57 per share the fund realized.
To make mutual funds even less attractive, we might also assume that your mutual fund share price has fallen in value. You might pay large capital gains on a fund that actually has a paper loss to you. The Pimco Innovation Fund is an example of this problem. This fund lost 28.22% during year 2000 but paid a taxable $6.35 capital gain distribution for that same year.
Private portfolio
This is my argument against holding mutual funds for investors with enough investment capital to structure their own portfolio and still show proper diversification. With a private portfolio, the investor controls his or her own realized capital gain status and the investor pays capital gains only on stocks that they actually owned long enough to receive the gains. They are not paying capital gains taxes on something they did not actually own full-term.
Private portfolio managers will also consider selling losing stocks to offset gains for their clients. Assuming many have large gains they would like to reduce, these sales normally drive prices of poorly performing companies down even more during the last few months of the year.
Mutual funds contributed in large part to the heavy trading that pushed the average daily volume of the New York Stock Exchange in 2000 to more than 140% of the previous year’s trading average. Many funds were selling long-held positions and realizing major capital gains.
Mutual funds tax issue
The capital gains issue is more visible now because the 30% plus annual returns of the past several years have created huge unrealized gains for many mutual funds. To maintain their tax protected status, mutual funds are required to divvy up all realized capital gains among shareholders each year. Shareholders are then required to pay tax on the gains even if they reinvested the proceeds in the fund.
If the funds are held in a tax-deferred retirement plan, capital gains are not a problem. For the individual investor, how ever, these large capital gains can crate a tax nightmare. If they do not pay attention to distribution announcements throughout the year, many investors do not know the gains are coming until year-end, or possibly a month or two into 2001 when the 1099 actually arrives.
Predicting whether your funds will realize large capital gains is an inexact science. Some advisers look at the Morningstar database to identify which funds have at least 25% of their assets potentially exposed to capital gains. The average frequency of trading is another indication that large capital gains may be on the horizon. If your funds recently hired a new manager or shifted strategy, they may do some shifting of assets in order to meet the new criteria. This will entail selling of currently held companies and purchasing of new companies that better fall in line with the new investment strategy.
Understand the consequences
Advisers often get their intelligence directly from the fund or fund manager. Usually the funds are cooperative. If a big distribution is coming, the adviser may sell the fund in advance of the distribution, particularly if returns have not been profitable. Many fund families will suggest another fund in that family that is posed for better returns. An exchange from your fund to another fund in the same family will constitute a sale without causing further commission charges.
Another option that advisers use is the sale of mutual funds realizing a loss to reduce the client’s total gains for the year and then replacing those funds with different funds or securities in the same sector. However, tax rules prohibit repurchasing the same fund or security within 30 days of the sale if you plan to take the tax loss. Under current market conditions with increased volatility, it is important that investors understand the possible consequences of mutual fund capital gains distributions. Investors cannot afford to pay capital gain taxes on investments that show a paper loss because fund share price has fallen.
For Your Information:
- Fred L. Dowd is a registered investment adviser and portfolio strategist with physician clients throughout the United States with offices at 104 S. Wolcott St., Ste. 740, Casper, WY 82601. He can be reached at (800) 252-3693; fax: (307) 234-3557; e-mail:fldowd@fldowd.com; Web site: www.fldowd.com.