Investors in some growth-oriented stock mutual funds are facing a big capital gains tax hit this year even though their funds may have lost money due to the market crash, investment experts say.
That is because many funds have or will distribute unusually hefty capital gains dividends to their shareholders before year-end. Those gains came about partly because mutual funds sold many of their more profitable stocks in the October collapse to raise cash to meet shareholder redemptions. Or, more likely, funds sold profitable stocks before the crash, worried that the market had gotten too high. The bulk of those profits must be passed along to shareholders.
May Be Angry
In some cases, the resulting dividends are as high as one-third of the value of the funds, far higher than the 5% to 10% normally distributed at year-end, says William E. Donoghue, publisher of Donoghue's Moneyletter, an investment newsletter based in Holliston, Mass. Investors in recent years generally did not object to those dividends because their stock funds overall had increased in value during the year.
Some funds apparently have not warned their shareholders about these distributions, choosing to wait until they are actually distributed, in some cases as late as Dec. 31, Donoghue says. That, he says, could leave some shareholders surprised--and angry.
"It's offensive to lose money and still have to pay taxes, and not be told a way to avoid it," Donoghue contends, adding: "Most people won't know about this until it is too late."
Acknowledges one mutual fund official: "Some poor shareholders won't know what hit them."
The situation was created in part by the Tax Reform Act of 1986, which requires funds to declare their dividends on a calendar basis by year-end.
Congress recently aggravated the situation. Its deficit reduction bill passed this week contains a provision requiring mutual funds to distribute 98% of the capital gains they incurred by Oct. 31 before year-end versus 90% under the previous law. The boost was a trade-off in exchange for Congress agreeing to postpone a provision that would, in effect, tax investors for the portion of fund income that went to pay management fees.
Thus, many funds that have already made distributions of 90% of their capital gains will have to distribute another 8% before year-end.
Funds that have already announced or made distributions include Columbia Growth, T. Rowe Price New Era, Dreyfus Growth Opportunity, Stein Roe Stock Fund, Smith Barney Equity, Founders Growth and Janus Fund, according to Martha Distler of Donoghue's Moneyletter. These and other growth-oriented funds generally lost a bundle in the stock crash.
For example, T. Rowe Price International Stock Fund had declined from a net asset value of $16.30 per share at the end of September to $13.12 on Dec. 17. On that date, it declared a dividend of $4.32 per share--amounting to 33% of its value. (It won't actually be paid until next month, although it will be taxable for this year.)
Investors with stock funds in individual retirement accounts, Keogh plans, 401(k) plans or other tax-deferred investment vehicles won't have to worry about the tax consequences for now. But other investors can avoid the tax only by selling their fund shares before the distribution is made, investment advisers say.
The value of each share of a mutual fund will decline by the amount of the distribution after it is made, just as the price of an individual stock declines by the amount of its dividend after it is paid. So an investor won't really miss out on the benefit of the dividend by selling before it is declared. For example, if a fund priced at $10 a share declares a $3 dividend, its price will then drop to $7.
However, by selling shares, investors will still be taxed on gains from the sale itself. But that may not be so bad because the top capital gains tax rate will rise next year to 33% from 28% now, advisers say. And if investors incur a loss on the sale, they can use the loss to offset capital gains or ordinary income.
For many investors, however, it may already be too late to sell to avoid tax on this year's dividends, said Burton Berry, editor of NoLoad Fund*X, a San Francisco newsletter. Investors may not be able to find out if their fund will pay a hefty dividend this year because most funds won't announce the date and amount of dividends in advance, he says. And even if they do, investors may not have enough time to act.
"I'm not sure there's much opportunity to do anything," Berry said. But if investors can avoid the dividend, they should try to do so, he said.