Capital-gains tax in a bad year Friday, November 14, 2008
BY DAVE CARPENTER THE ASSOCIATED PRESS CHICAGO — Talk about kicking investors when they're down.
A required year-end practice by mutual funds is about to whack many people with capital-gains taxes at the cruelest of times: when funds already have declined by as much as 40 percent this year.
Even though a fund's value has declined, it may have realized capital gains — profits from selling specific securities in the portfolio. Usually such gains draw no more than brief grumbles from investors because they know that comes with investing in mutual funds.
But when individuals find out they have to pay taxes in one of the worst years in stock market history, it's likely to stir outrage among those who pay little attention to the process.
After all, 99.9 percent of equity open-end funds had negative returns for 2008 through Oct. 31 and the average fund lost 35 percent, according to Morningstar Inc.
Paying capital gains even when your funds decline is rare but not unheard of. Still, how could it happen?
The Internal Revenue Service requires mutual funds to distribute substantially all of their income to their shareholders, who must then report the distributions as income and pay taxes on them. This year, funds realized gains from stocks sold before their value plummeted.
Then when the financial crisis hit, investors pulled a record $46.5 billion out of U.S. mutual funds and another $40.5 billion in October. The forced selloff led funds to record significantly more capital gains.
If your fund investments are in tax-sheltered 401(k)s or IRAs, you needn't be concerned. But shareholders of other funds face what could be a significant double whammy with ill-timed distributions on top of their whopping personal losses.
Investors in buy-and-hold mutual funds paid a record $33.8 billion in capital-gains taxes in 2007 — painful but understandable for a year dominated by a bull market.
While 2008 distributions are not expected to reach last year's record level, investors could feel substantial pain from funds that have been on a roll in recent years and had built up a lot of unrealized capital gains. Emerging market funds, some other international funds and funds invested in commodities and natural resources stocks fall into that category.
Long-term capital gains are taxed at 15 percent for most taxpayers and 0 percent for low-bracket taxpayers. Short-term capital gains, profits on the sale of securities held less than a year, are taxed as regular income.
Individuals can sell funds now to try to dodge the distributions, but such moves often are ill-advised. "In most cases you're probably not going to be better off by doing that," said Christopher Davis, a fund analyst at Chicago-based Morningstar. "Most people really can't game the system. Especially if you're a long-term owner and you've made money, you're going to pay taxes sooner or later."
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