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WALL STREET, CALIFORNIA | PORTFOLIO STRATEGIES

How to Make Capital Gains Distributions Less Painful at Tax Time

October 24, 2000|JOSH FRIEDMAN

After watching that technology stock mutual fund soar in 1998 and '99, you jumped in early this year--right near the sector's peak.

You've got a big paper loss on the investment. Yet your fund now is telling you you're going to get a taxable capital gains payment for the year--for "gains" you never benefited from.

Ouch. Ouch! Lousy returns and somebody else's tax bill. Now that's a double-whammy.

Welcome to the complicated world of mutual fund taxation.

In years past, when mutual funds were routinely racking up annual returns of 20%, 30% or more, the tax bite from capital gains payments may have annoyed investors, but at least they saw their investment advancing as well.

This year is different: Some of the hottest funds have plunged from their winter peaks. Yet they still will be making taxable capital gains distributions.

For the Record
Los Angeles Times Wednesday October 25, 2000 Home Edition Business Part C Page 3 Financial Desk 2 inches; 53 words Type of Material: Correction
Fund distributions--A chart in Tuesday's Business section listed incorrect dollar amounts as preliminary estimates of capital gains distributions for two mutual funds: For Janus Overseas, the preliminary estimate should have been $5.13 a share, and for Janus Equity Income, the preliminary estimate should have been $3.32. The percentage payouts listed were correct.

"I expect there to be some pretty unhappy people," said Philip J. Holthouse, partner at a Los Angeles tax law and accounting firm. "This is the first year in which a lot of people will have the bad tax answer without the good investment return."

What are these fund distributions, who needs to be concerned about them, and what can you do to lessen the financial pain?

Here's a look at the issues:

What are fund capital gains distributions?

Under federal law, mutual funds are required to pay out any net realized capital gains to their shareholders each year. These gains, which derive from stock trades or other investment income, can be short-term or long-term or a combination of the two.

The type of gain, and therefore its tax treatment for investors receiving it, is based on how long the fund held a particular security--not on how long an investor has owned the fund.

For tax purposes, most funds close their books Oct. 31. Typically, they then tally their capital gains situation in November and pay distributions in December. But payments can be made at any time of the year.

In part because of the explosive stock market in the fourth quarter of 1999 and first quarter of this year, financial advisors are bracing for a potential onslaught of big fund distributions this December--many from funds whose fortunes have soured since spring.

"I always call around to the fund companies to find out about distributions, and last year at this time I was getting pretty fair estimates," said Jennifer Cagle, associate portfolio manager at the Keller Group, a planning and investment firm in Irvine. "But this year I've gotten zero response. Our assumption is a lot of them may not have great news."

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Should I care about distributions if I own my funds in tax-sheltered accounts?

Probably not. If your funds are in tax-sheltered retirement accounts such an IRA, 401(k) or 403(b) account, any payout you get remains tax sheltered.

Even investors who own funds in taxable accounts may just want to continue gritting their teeth and paying the tax bill if they have been in the fund a long time and plan to continue holding it.

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Who really needs to worry about distributions?

Capital gains payments could be of most concern to investors who bought funds in taxable accounts late last year or early this year and now are underwater.

In effect, these investors may be picking up the dinner check for shareholders who already ate and left. Paper gains from stock holdings may have boosted a fund's share price earlier this year. Those investors who sold out of the fund in spring may have caused the fund manager to sell stocks to cash them out.

Now, those investors who still own the fund may be getting the gains realized in the spring--even though the fund itself has lost value since. Such is the nature of the mutual fund structure.

After the market rally of 1999, investors poured a record $130 billion into stock funds in the first quarter of 2000, much of it in sectors that had been sizzling. In some cases, all these new investors will be getting is a costly lesson in the price of performance-chasing.

Asian stock funds and those from other market areas that have cooled off--such as technology--are particularly ripe for the double-whammy of big distributions in a down year.

A fund with a recent history of big unrealized gains, then substantial shareholder redemptions, can be a prime candidate for a potentially large distribution.

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How can I lessen the damage of a planned distribution?

First, try to find out if you really need to take action: Call your fund company or visit its Web site and check to see if the company is estimating what your fund's year-end distribution may be, and when it will be paid.

Note that most fund distributions are modest (the vast majority are worth less than 10% of the fund's net asset value per share). But the bigger your fund portfolio, the bigger the potential tax bite you may face.

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