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 November 2005 Mutually Taxing
Despite the daunting Schedule D where they're reported, capital gains are one of the U.S. tax code's easier concepts to grasp. In essence, the difference between the purchase price of an asset and its current market value is its capital gain (or loss). When you sell the asset you "realize" this gain (or loss) and it becomes reportable on your income tax for the year in which the sale was made. When you file your 1040, capital losses net against capital gains, so the two can offset one another. As a result, an investor with the good fortune to realize some capital gains can reduce or even wipe out the tax liability by selling other assets to generate offsetting losses. All of this, of course, has to be done by the end of the year. That's why many investors spend November and December harvesting losses to offset prior months' gains. (Professional money managers do this too, not only to minimize taxes but for year-end window dressing as well. In an effort to get out ahead of the retail sellers, they've been doing this earlier and earlier each year, contributing to the rough September and October markets, but that's a story for another day.)
Of course one of the best ways to avoid the whole problem is to simply hold onto both winners and losers. That way you don't realize any gains so there's no need to offset them by selling losers. Arguably this is one of the biggest benefits of a buy-and-hold approach. There is, however, one very important instance where this strategy won't work: mutual funds. Ironically, the investment that's usually hawked as most appropriate for individual equity investors isn't nearly as straightforward when it comes to taxable capital gains. Consequently, many investors will get a rude surprise when April rolls around. Indeed, April 2006 may offer the biggest surprises in five years. No Trade, Just TaxJust like a stock, if you sell a mutual fund for more than you paid (including reinvestment of distributions) you realize a taxable capital gain. If you sell it for less, you generate a loss that can be used of offset other gains. No difference there.But for mutual funds, the taxable capital gain story doesn't just stop there. Instead, there's another way taxable gains can occur, and investors have no control over it.
To see how this comes about, recall how a basic, open-end mutual fund works. It's not just one investor but rather a collection of investors holding undivided interests in all of the fund's assets. Although each individually decides to buy into the fund, there's an investment manager deciding how to invest the fund. Whereas the individual shareholders decide when to buy or sell the fund, the investment manager decides what securities to buy or sell within the fund. Both have the potential to create taxable gains, yet fund investors only have control over the former. That may sound confusing, but it's really not. This is one of those cases where an example with an illustration will be helpful, so consider Chart 1 which details the purchase, capital gains distribution, and tax liability for an investor in an established equity mutual fund. Step one is the initial fund purchase. In this example, we're assuming each fund share costs $50, so that becomes your initial cost basis. It's represented by the first column in Step 1. The second column shows what you've bought. It's tempting to say you've bought $50 worth of stock, and you have, but that stock was purchased with funds from three different sources. The first is cash brought in when investors purchase fund shares. Your $50 is part of this. If the fund was just starting up and didn't already hold any stocks, all $50 of its holdings would be cost basis, but that's rarely the case. Instead, our example illustrates the vast majority of purchases of funds that have been around for years. When you buy them, they're already invested and simply use your cash to buy more stocks. In this example, it represents $20 of the fund's $50 asset value per share and appears as the blue part of the second bar. Some of the fund's stocks have gone up in value. It still holds them, so no capital gains have been realized. Nevertheless, this appreciation represents part of the fund's value. In this example, it's the $20 represented by the green segment of the second bar in Step 1. The final element is realized capital gain. If your fund manager does a good job, he or she will buy low and sell high (isn't that why you picked this fund in the first place?) Just like an individual investor, when the fund sells a stock for a gain, a capital gain is realized. At that point the proceeds from this sale (including the gain) are available for reinvestment. In our example, the red part of the bar represents $10 of realized capital gains that have been reinvested within the fund. So to put it all together, your $50 purchase is initially composed of $20 cost basis, $20 unrealized gain, and $10 realized capital gain. At this point, the realized capital gain is still within the fund, so you do not have a taxable capital gain. This is shown in the final column of Step 1, which at this point is $0. Now, let's assume several months elapse and we're approaching the end of the year. The fund has done well and each share now costs $70. You've done well, too, because you've made $20 on your initial $50 investment. If you sold the fund now, it would be just like selling an appreciated stock, your taxable capital gain would be the difference between the purchase and selling price, or $20. Instead, however, let's assume you don't sell. In that case, Step 2 of Chart 1 would show the current situation. Since you haven't bought or sold any shares, your cost basis (the first column) remains unchanged at your initial purchase price, $50. The increase in share value has come from an additional $10 unrealized capital gain as well as another $10 realized gain. This is illustrated by the second column. At this point, all of the gains are still within the fund, so you still have no taxable gain. That's why the final column in Step 2 is still $0.
So far the tax consequences have been no different than they are for a stockholder, you only incur capital gains liability when you buy or sell the fund. At this point, you're still in control, but that changes when the fund makes a gain distribution. Before seeing how that works, let's take a few minutes to see why it happens. Mutual funds are actually investment companies, and as such, are taxable entities. Like individual investors, their realized capital gains are taxable for the tax year in which they are incurred. In our example, the $20 realized capital gain in Step 2. The fund must pay tax on this amount unless it distributes it to shareholders before the end of its fiscal year. In a sense, the realized gains within the fund are like the old game of "hot potato": Whoever holds them at the end of the fund's fiscal year -- whether it be the investment company or the shareholders -- has the tax liability. Mutual funds as a rule don't pay taxes because they always distribute all their taxable gains to shareholders by the end of the year. Unlike a stock owner deciding whether or not to take a gain, fund shareholders have no control over this. Chart 1's Step 3 shows what happens when the fund makes its distribution. Again, since you're not buying or selling, your cost basis (first column) remains unchanged at $50. The value of the fund's shares falls by the amount distributed ($20), and you now have a taxable capital gain (final column). Notice what's happened: The fund is back down to your initial purchase price of $50, but now you also have the $20 gain on hand. Unfortunately, you won't be able to keep it all since you're liable for the taxes on it. This is exactly the same situation you would have been in had you elected to sell the fund shares and then immediately buy them back. In essence, you've been forced to take your gain and pay the tax now rather than later. As a fund shareholder, you have no choice. Ironically, had you purchased the fund the day before the distribution, you still would have received a gain distribution. You would have had to have paid $70 per share rather than $50, but you still would have gotten the gain and witnessed the share price drop to $50. In that case you would have simply had $20 of your purchase price given back to you as a taxable event. At least you'd then have a $20 unrealized loss (the difference between the $70 purchase price and $50 after-distribution price) that could eventually be used to offset future gains. By the way, automatic reinvestment of capital gains has no effect on your realized or unrealized gains. In this case, you wouldn't get a check for the $20 distribution but rather have it reinvested back into the fund. Your cost basis would be increased by $20 but so would the value of your investment. No Gain, Just TaxBack in the heady days of the late-1990s, equity fund managers were active traders. Returns were great, but capital gain distributions were high. For instance, the Investment Company Institute says mutual funds distributed $114 billion in 2000. A lot of fund investors got a rude surprise when they filed their taxes.But the bear market eliminated the problem in the following years. As stocks fell, funds had few if any gains to distribute. Many actually incurred losses and were able to use them in subsequent years to offset losses (see Their Loss is Your Gain).
Distributions fell off sharply in 2001 and stayed low until moving up sharply last year (see Chart 2). This year they're expected to show yet another major increase. The fact that stocks haven't done much -- and may even close the year with a loss -- won't change this prediction. That's right, investors can get hit with taxable gains even when the fund distributing them is down for the year. Chart 3 shows how this can happen. Like the previous example, it starts off with the purchase of shares initially priced at $50. The share composition (cost basis, unrealized, and realized capital gain) is also the same. As time passes, stocks go down so in Step 2, the unrealized appreciation has declined from $20 to $5 while the realized gains have, as in the first example, risen from $10 to $20. Since no gains have been distributed at this point (third column = $0) you could sell your shares and walk away with a $5 capital loss ($45 - $50). But if you hold on, the gain is distributed (Step 3) resulting in a $20 realized capital gain. The share price falls by this amount to $25 and your cost basis remains unchanged at $50, leaving you with a $25 unrealized loss. That's the worst of all possible worlds: A taxable gain and a loss in the fund. This could easily be what's in store for many fund investors this year. Year-End StrategiesFortunately, this doesn't have to happen if you act before year-end. You can't stop your fund from distributing its gains, but there are things you can do to minimize or even eliminate its impact on your 2005 taxes.The first thing to do is check with your fund to see if and when it will be making gain distributions. If you're lucky it's not and you won't have to do anything else this year. On the other hand, if it is making one, the date is very important. If you don't already own the fund but are considering buying in, you'll want to wait until after the distribution becomes payable to buy in. Remember how the share price fell by the amount of the distribution in both of the earlier examples? By waiting until after the distribution, you'll be able to buy more shares for the same amount invested. More importantly, you won't get stuck with the taxable capital gain. The one exception to this is if you're dollar cost averaging into the fund. The benefit of this approach comes from investing equal dollar amounts on a regular basis and it's disrupted by ad hoc changes to the process. It's usually best to stick with your investing pattern even if the fund is about to make a distribution. Besides, the amount of this incremental investment will add very little to your gain exposure. Your options are a little more complicated if you already own the fund. If you have an unrealized loss (you paid more than the fund shares are currently worth), you might consider selling the fund and realizing the loss before the gain is payable. (In our examples, this would be equivalent to selling at Step 2 prior to the distribution in Step 3.) Rather than facing a taxable capital gain, you'd end up with a capital loss that could be netted against other gains in your portfolio or, within limits, applied against regular income. In determining the size of your loss, remember if you're reinvesting gains and dividends, prior distributions should be added to your cost basis as in Step 4 of our examples. Many investors fail to do this and only consider the cost of their initial investment. That helps Uncle Sam but not those making this mistake. Don't be one of them. Unless the fund was a one-off purchase or a hot tip from a friend, you probably own it to fill a certain niche in your portfolio. Once you sell it, you need to replace it. Don't worry, there are plenty of funds out there with the same objective and quite possibly better returns. Sources like Morningstar will allow you to search on objectives and compare fund characteristics and performance. Before buying though, remember to check with the fund to see if and when it will be making a capital gains distribution.
A word of caution: Don't simply sell your current fund and then buy it back a few days later. If you don't own it when gains are distributed you would avoid them, but you would fail to capture the capital loss because your transaction would run afoul of the "wash sale" rule. According to the U.S. tax code, a wash sale occurs when you sell a security and replace it with "substantially the same security" within a period spanning 30 days before the sale to 30 days after the sale. When this occurs, you cannot take advantage of the loss. (For a complete description of a wash sale and its consequences, click here.) If you already have a gain in the fund, selling before the distribution might still be the best course of action. You have to do a little math to make this determination. As always, start by contacting the fund to see if and when the distribution will be made. Also ask for its estimated size. The exact distribution is often determined right before its paid, but the fund should be able to give you an estimate which is usually a "per share" figure. Multiply this amount by the number of shares you own to get an estimate of your potential gain from the distribution. Next calculate the gain you would realize by selling the fund. This is the difference between your cost basis and the current value of the fund. Again if you're reinvesting gains and dividends, don't forget to add the value of prior distributions to your initial cost. If this value is less than the value of the upcoming distribution, you're better off selling the fund now. Either way you have a taxable gain, but at least this way you've minimized it. On the other hand, if the gain from selling the fund is greater than the distribution, don't sell. Yes, you'll have a taxable gain, but at least it will be smaller than what it would be if you sold. When you are faced with a gain, either from selling or from the fund's distribution, you might want to look elsewhere in your portfolio to see if it's possible to harvest some offsetting losses. Remember, capital losses net against capital gains and they don't have to be generated by the same security. (For an overview of the tax treatment of capital gains and losses, click here.) It's highly likely that your equity mutual funds will be distributing capital gains this year. You can't stop them but you can work to minimize the impact. The key is to act now, before the actual distributions and before year-end. The wisest taxpayers are like the best investors, they're well-informed and proactive. Search this site! Just enter you key word or words:
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S THE YEAR DRAWS TO a close, it's time to think about last-minute actions that might reduce your tax bill come April 15. For investors, this often means a review of their investments with an eye towards capital gains.
