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Law Brings New Reasons to 'Tax Timing' Season

October 26, 1997|CHARLES A. JAFFE | Charles A. Jaffe is mutual funds columnist at the Boston Globe

"Wait till next year" is usually the talk of baseball and football fans whose favorite teams have been banished to another season without a championship.

Right now, however, it is also the cry of investment advisors cautioning mutual fund investors to avoid making big purchases before the end of the year.

The reason is "tax timing," the ability to pick when you want to pay Uncle Sam his due on your gains. And this year, thanks to recent changes in the tax code, there is not only an incentive to delay purchases, there may also be a reason to sell some of your long-term winners during 1997.

The specifics of the tax code are likely to make your eyes glaze over, but force yourself to push on to see how buying or selling cautiously now could make for big tax savings later.

Here's the way it works: By law, a mutual fund must pass 98% of its realized capital gains (i.e., gains actually taken during the year by selling securities) to shareholders before Dec. 31 each year. Most funds make the payout in late November and December.

If you buy into a fund shortly before the gains are doled out, you still get the full payment--and thus face taxes on that full amount--even though the fund achieved those gains before you came aboard.

Say, for example, you invest $5,000 in a fund whose current share price is inflated by a 23.5% realized capital gain for the year.

When that gain is paid, you will get $1,175 from the fund, which will be part of your taxable investment earnings for 1997 (whether you take it in cash or, as do most investors, reinvest the gain in additional fund shares).

The value of the shares you bought, meanwhile, will drop by the per-share amount of the gain paid to you. In essence, you're getting back some of the money you just put into the fund. You don't lose principal--but you do lose, in effect, because of the sudden tax bill on the gain.

That's why many investment advisors say you should postpone making large purchases of mutual funds in November or December, until the fund you're interested in has paid out its gains for the year.

The risk, of course, is that the stock market could soar while you wait. (If the market falls between now and the payment date, by the way, note that the gains payment most likely will still be made, because it represents gains previously achieved.)

There also are several exceptions to the waiting rule:

* If you're buying a fund within a tax-sheltered account, such as a 401(k) retirement plan or individual retirement account, you won't face an immediate tax bill, so year-end timing isn't necessary.

* Unlike stock funds, bond funds generally don't realize big capital gains unless market interest rates plunge during the year. Rates are lower this year, but modestly so, so huge capital gains payments on bond funds aren't likely.

* If you're buying a stock fund that specifically attempts to be "tax efficient"--that is, the fund tends to buy and hold securities, rarely trading but, rather, allowing gains to accumulate unrealized--there may be no reason to postpone a purchase, because any year-end gains payment may be minimal.

For example, "index" funds, such as those that seek to replicate the performance of the Standard & Poor's 500 index, generally are tax efficient.

This year, investors may have additional incentive to avoid buying into funds that are on the verge of paying out big capital gains.

As a result of the new tax law, there are different tax rates on different types of gains. Gains on assets held at least 12 months and sold before May 7 of this year will be taxed at a top rate of 28%.

By contrast, gains on assets sold on or after May 7 after being held at least 18 months will be taxed at a top rate of 20%.

A mutual fund, in making its annual payout, will have to segregate gains depending on when securities in the portfolio were sold and how long they were held.

Thus, some funds may pay out far more in gains taxable to you at the 28% rate, whereas others may pay out more in gains taxable at a 20% rate.

The change in tax rates and holding periods may also prompt you to sell funds now--if you were considering doing so soon anyway--rather than wait until after capital gains payments are made.

Why? Say a fund realized a lot of long-term gains before the tax-cut date of May 7. Those early-in-the-year gains could be taxable to you at the 28% rate.

But if you have held the fund for more than 18 months, and sell it before gains for this year are paid, your applicable tax rate under the new law would be just 20% on your entire gain in the fund.

The challenge with all of this is figuring out what a fund actually plans to pay in gains, and how it will be taxed. The more you know, the more intelligent a buy or sell decision you can make.

It's worth calling your fund companies to ask whether they will soon have estimates of year-end payments, the date they plan to pay, and whether they will have an estimated breakdown by tax rates.

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