Fund Taxes Likely Small in '09


You know that annual warning about tax bills that can accompany year-end mutual fund purchases?

Well, it turns out this may not be such a problem this year. Many funds can use losses from 2008 to offset gains in 2009, keeping the problem of “year-end distributions” to a minimum.

Morningstar (Stock Quote: MORN), the market-tracking firm, reports that many funds will have unusually small distributions this year, though there will be enough exceptions to make it worth checking before making a purchase. Most fund firms now have lists of expected payouts on their Web sites.

The problem involves profits funds earn from selling stocks, bonds or other assets during the year. When those sales produce net gains, the fund must pay them out to investors by the end of the year.

The distributions, typically made in December, show up on the 1099 form sent by the fund in January. Even if the distributions are used to buy more fund shares, they are subject to short- or long-term capital gains tax unless the fund is held in a 401(k), IRA or other tax-favored account.

Investors are typically told to postpone late-year purchases until after distributions are paid to avoid the tax. All else being equal, a fund’s share price falls when the distribution is paid, reflecting assets removed from the fund. That means nothing is lost from missing the distribution. A $10 share will fall to $9 after a $1 distribution, for example.

While funds must distribute net gains from asset sales, there is no similar mechanism for distributing net losses. However, a fund can hold on to losses and use them to offset gains in future years. Although many funds have realized sizeable gains this year, they are able to use losses from 2008 to reduce or eliminate required distributions.

Vanguard Group reports that most of its funds will have no distributions. Most of Vanguard’s distributions are in bond funds. T. Rowe Price (Stock Quote: TROW) also says its distributions will be small, as does Fidelity Investments.

Still, there are a few sizeable payouts. Vanguard’s Extended Duration Treasury exchange-traded fund (Stock Quote: EDV) will pay $11.19 per share, with shares currently trading around $100. A $10,000 investment would pay out $1,119. Because this will be a short-term gain, the tax bill would be $279.75, assuming a 25% tax bracket. You could avoid that tax by postponing a purchase until after the distribution is paid.

Though distributions may not be large this year, they could be sizable in the future if the market continues its rebound and fund companies use up the losses held over from 2008. Investors should therefore check a fund’s distribution history before buying shares. Certain types of funds, such as actively managed ones with high turnover in assets, tend to make larger distributions than others, such as index-style funds.

If you want to purchase a fund likely to make big distributions in the future, consider buying it through a 401(k) or IRA. That way you will avoid annual tax on distributions. Tax will not be owed until after you sell the fund shares and withdraw cash. There would be no tax at all of you invest through a Roth IRA, which exempts all gains from tax.

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