MARKETS
Consider tax impact of buying, selling
Mutual funds can work for, against investors
By KATHLEEN GALLAGHER [email protected], Journal Sentinel
Sunday, October 19, 2003
Thinking about buying or selling a mutual fund?
This is the time of the year when tax considerations can influence those decisions, particularly when you’re buying.
Take Carl, a Milwaukee-area investor who wants to dump shares of his Janus and Strong mutual funds. New York Attorney General Eliot Spitzer accused both fund companies in September of giving a New Jersey hedge fund preference over other shareholders in exchange for an investment in some of its other products.
Carl wants to redeem his shares before the end of the year.
“At the same time, I would like to reinvest the remaining funds into other mutual fund offerings this year,” Carl said.
Carl has losses in the funds he wants to sell, and the funds aren’t held in retirement accounts.
The biggest factor in the sell decision should be whether or not Carl can use his losses to offset gains in other investments, said Nicholas Enea, a financial planner at WFA Asset Management Corp. in Franklin.
“You don’t just sell because something is at a loss — why take a loss if you can’t use it?” Enea said. “The primary decision factor is, ‘Do we need these taxable losses to offset gains?’ It’s not, ‘Should we wait to see the capital gain distribution or not?’ “
The capital gain distribution that a fund may be poised to make is important, though, when you’re buying fund shares.
Fund companies usually distribute their accumulated capital gains between October and December. Investors who buy shares shortly before the distribution get penalized from a tax perspective because they end up paying taxes on gains they didn’t benefit from earlier in the year. Then the fund’s net asset value drops by the amount of the distribution, and investors end up with a tax bill and a fund that’s worth less.
The easiest way to avoid getting hit with uninvited capital gains, Enea says, is to wait until Jan. 2 to buy any mutual funds.
If Carl doesn’t want to wait, though, Kunal Kapoor says he can call the companies that manage the funds he’s thinking of buying to ask about built-up capital gains.
“If you have any questions, the obvious and best place to start is by calling the fund company,” said Kapoor, associate director of fund analysis at Morningstar Inc. in Chicago.
“If they don’t give you the information, or say they don’t have it, I would wait until they’re ready to share that with you.”
Once you have the information about whether there will be a distribution and what the record date for it will be, you can arrange to buy the shares after the record date, said Frederick Blue, head of mutual fund product management for the TIAA-CREF fund family based in New York.
If Carl is buying funds he intends to hang onto for a long time, he shouldn’t worry too much about the capital gains distribution issue because the impact will be dulled over time, Blue said.
“If it’s a more short-term situation, and you’re looking to purchase a fund but avoid tax consequences, then you might want to find more tax-efficient funds with a history of retaining most of their earnings or a low turnover rate,” Blue said.
Investors can find such information on the Web for free at www.morningstar.com. After you enter a fund name or ticker, click on “tax analysis” on the left side of the screen to get tax information about that fund.
The information includes its tax cost ratio, which shows the reduction in return that results from income taxes, and the fund’s potential capital gains exposure, which shows how much of the fund’s assets would be subject to taxation if the fund were to liquidate today.
The category fund buyers should be most cautious about buying now is small-cap value funds because they likely have the most pent-up gains, Kapoor said.
“They’ve been on a tear — they did well in the bear market and have continued to do well,” he said.
Investors should be cautious, too, about two other high- performing categories of late — high yield and emerging market bond funds — and research whether they’ll be making capital gain payouts before buying them, Kapoor said.
In general, because their recent performance hasn’t been as good, growth funds have more losses built up than value funds, Kapoor said. That means many growth funds have the advantage of being able to offset current gains with losses they’ve carried forward, meaning their shareholders have potentially fewer capital gains they have to pay tax on.
The recent tax break for dividends might also make funds that invest in large, more mature companies with a history of paying dividends more attractive, Blue said.
Kathleen Gallagher covers the financial markets for the Journal Sentinel. She can be reached at (414) 223-5460 or [email protected].
MARKETS HIGHEST RETURNS
Morningstar Inc. ran a list of all the U.S. stock funds that did not have their three-year average annualized return reduced by taxes. Here are the 10 funds from that list with the highest total return over that period.
FUND/TICKER TOTAL RETURN
Alpine U.S. Real Estate Equity (AUEBX) 23.70% Legg Mason U.S. Small Cap Value (LMSVX) 13.81 RS Global Natural Resources (RSNRX) 12.26 State Street Research Global Resources (SSGDX) 11.56 Skyline Special Equities (SKSEX) 11.35 Kinetics New Paradigm (WWNPX) 11.16 Fidelity Select Automotive (FSAVX) 10.75 Texas Capital Value & Growth (TCVGX) 12.36 Seligman Small Cap Value (SSVDX) 10.11 RS Contrarian Value (RSCOX) 8.61
Source: Morningstar Inc., Chicago
