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Wiles: Mutual funds: Getting a tax bill even with a big loss

Talk about adding insult to injury.

Many investors are likely to receive a capital-gains tax bill on their mutual fund holdings later this year – despite widespread stock market losses in 2008 and even if they don’t sell anything.

“Clients don’t expect it this year,” said B.G. Malamut, a certified financial planner at Ameriprise Financial in Phoenix. “They’ll be surprised and very upset.”

Actually, not all fund investors will be impacted. If you invest in mutual funds within an IRA, 401(k) plan or other tax-sheltered retirement vehicle, there’s nothing to worry about. Similarly, most bond funds aren’t likely to pass along much if anything in the way of taxable capital gains.

But many stock funds will, so investors holding shares in taxable accounts should beware.

“We are seeing a trend that could be quite alarming to many people,” said Tom Roseen, a senior research analyst for Lipper Inc. in Denver. The combination of personal losses with taxable distributions is “the double whammy we all fear,” he said.

All this begs a fundamental question: How can investors be billed for a tax gain during a year when they see their holdings plummet? The answer relates to the quirky nature of mutual-fund taxation.

Simply put, fund companies are required under the nation’s tax code to make payments to shareholders that reflect profits realized on stocks or bonds sold by a portfolio manager.

Losses don’t get the same treatment but, instead, are used to offset gains. Excess losses are carried forward to offset gains in future years, but excess gains must be passed along to shareholders as taxable distributions in the current year.

Gains and losses aren’t taxable until they’re actually locked in when a manager sells. Many fund managers try to avoid realizing taxable gains for just this reason, but some have been forced to sell holdings lately to meet redemption requests from panicky shareholders.

Roseen predicts funds owning foreign stocks or commodity/natural-resources shares are more likely to pay taxable distributions in coming weeks, since those had been sources of hot money, having attracted buyers with a short-term focus.

Equity-oriented funds in general have suffered billions of dollars in net cash outflows this year, forcing many to sell stocks.

Already, some firms are warning shareholders of taxable distributions ahead. For example, the American Funds estimates it might make taxable distributions on more than a dozen funds. These could include payments of up to 9 percent of the share price of the New Perspective Fund, 6 percent for New World and 5 percent for EuroPacific Growth.

At the Vanguard Group, only a handful of actively managed funds and no index funds had realized gains through September, and most of the few distributions were small, said John Woerth, a Vanguard spokesman.

“However, given the market activity in October, these figures could change,” he cautioned.

And that’s the point of this exercise – to encourage you to call your fund company or check its Web site to find out what taxable-gain distributions might be in store.

You can prepare for, cushion and even avoid an upcoming distribution in several ways. For example, you could sell some other money-losing investment and use that to offset some or all of an upcoming capital-gain distribution.

Also, you could sell the fund in question before the “record date” and avoid receiving the distribution. Shareholder record dates typically fall in November or December.

Conversely, if you’re thinking of making an investment, you should avoid doing so until after the record date to avoid getting a taxable payout.

If you do get saddled with a taxable-gain distribution this year, above all you should keep good records. The reason: When you ultimately sell your fund shares, you can reduce your future gain (or maximize any taxable loss) to reflect taxes paid along the way on distributions that you reinvested into additional shares.

Contact Russ Wiles at russ.wiles@arizonarepublic.com

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