Thanks to Saddam Hussein, many mutual fund investors could get a nasty surprise early next year. They might have to pay taxes on fund distributions even though their funds lost money this year.
For most of 1990, many equity or stock funds did fairly well, even though the stock market was sluggish. But when Iraq invaded Kuwait, the markets and the funds fell. As a result, many funds have already received dividends and other income from their investments, but their own share prices are down."This also happened in 1987," when the market crashed in October, says Steven E. Norwitz, a vice president at T. Rowe Price Associates, a Baltimore mutual fund company.
Mutual fund distributions often trip up investors, usually about this time of the year. The most common mistake people make is buying fund shares just a few weeks before the fund makes its annual distribution to shareholders. Mutual funds have to distribute 98 percent of the capital gains and ordinary income they receive each year by Dec. 31. Most funds do this in the last two or three weeks of December, based on income received by the end of October.
The distribution is "received" by investors whether the fund sends them a check or reinvests the money to buy more shares. So even if they don't see the money, they have to pay taxes on it, unless the fund is part of a tax-deferred vehicle, such as an Individual Retirement Account.
For investors who have been with the fund throughout the year, or most of it, there is no problem with this distribution system. But for new investors who get in just before the distribution date, it might mean getting a distribution - on which taxes have to be paid - before they've made any profit. Say you put $10,000 into a fund on Dec. 3. Then on Dec. 10, the fund pays $500. The share price of the fund may not have changed, but you have $500 in taxable income.
You can avoid this problem with a phone call. "If a client is ready to get into a fund we call the fund and find out the distribution date," and send in the money after that, says Beth Gamel, a financial planner in Lexington, Mass.
Generally, though, "this is not an overriding issue for us," she says. Other issues, such as whether this is the right time to get into a fund and what kind of fund to invest in, come first. However, "if the distribution is coming up quite soon, we'll usually wait," she says.
Apart from saving taxes, waiting a week or two might also give investors more shares for their money. The share price, or net asset value, of mutual funds usually falls slightly after a distribution, so if price is $20 before the distribution, it might be $18 after. So instead of buying 500 shares with that $10,000, you'll get 555.
"We don't pay a whole lot of attention" to the tax issue, says Craig Litman, a partner in Litman/Gregory & Co., a financial management firm in San Francisco that tracks funds sold without a sales charge. For one thing, he says, many funds have had a rough time of it this year and aren't going to be making a distribution payment, anyway, but they may have good long-term records. In that case, an investor should consider buying them now when their price is low, Litman said. For example, he noted, the Gabelli Asset Fund and the Brandywine Fund have both lost money in the past year, but for the past three years, they have an average annual return of more than 15 percent.
Most funds can tell you within a few days what the distribution date is, though the telephone representative may not be able to tell you how big it will be. For that, you'll have to wait for an announcement from the fund, or call again after the expected distribution date.
While some investors may be thinking about buying, others who have lost money on their funds may be thinking about selling, particularly if they're trying to push deductions into this year because of the new tax law. But consider this: The Internal Revenue Service frowns on something called a "wash sale," where an investor sells a security to declare a loss, then buys it back within 31 days.
So if you sell, don't put your money back into the same fund for at least 31 days; otherwise, you'll trigger the wash sale rule and the loss won't be deductible.