Mutual fund methods
If you invest in mutual funds, proceed cautiously
at year end. At this time of year, funds may distribute
any net capital gains for 2009 to their shareholders.
These distributions are taxable to investors (unless
the fund is held in a tax-favored retirement account),
and the share price typically drops to reflect the
distribution.
Example #1:
Caitlin Carter invests $10,000 in Mutual Fund ABC
in early December 2009. She acquires 500 shares at
$20 apiece. One week later, ABC makes a $2-per-share
capital gain distribution, and the share price drops
to $18. Caitlin owes tax on a $1,000 capital gain
distribution ($2 per share times 500 shares) - even
though the distribution is essentially a return of
her own money.
Therefore, if you are going to invest in a mutual
fund between now and December 31, 2009, you may be
better off waiting until after any distribution. You
might be able to avoid this tax trap and buy at the
post-distribution reduced trading price. Check the
funds website for information about capital gain distributions;
if the fund won't distribute capital gains because
of bear market losses, you can buy at a time of your
choosing.
If you are thinking of selling mutual fund shares,
on the other hand, you may decide to advance your
plans if you learn that your fund will make a capital
gain distribution.
Example #2: Steve
Davis invested $10,000 in Mutual Fund XYZ many years
ago. He now owns 700 shares of the fund, trading at
$25, for a total of $17, 500. Steve wishes to take
his gains in 2009 while the maximum tax rate on long-term
gains is 15%.
On the XYZ website, Steve sees that a $3 per share
distribution is planned for December 15, 2009. The
fund estimates that $2.50 per share of that distribution
will be in the form of short-term capital gains from
this year's rally. Thus, if Steve holds onto his shares,
he will receive a distribution of $2,100 ($3 times
700 shares), most of which will be taxed in his 28%
ordinary income tax bracket as short-term capital
gains.
Instead, Steve sells before XYZ's distribution. With
a $10,000 cost basis and a $17,500 selling price,
Steve will have a $7,500 long-term gain, all of which
will be taxed at only 15%.
