Year-end Mutual Fund Tax Hits

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Question:  If I buy a mutual fund in a taxable account before the end of the year, will I have to pay taxes on year-end distributions?  

Answer:  Yes, you will be taxed on distributions if you own the fund on the record date.  It doesn’t matter how long you have owned it, and it doesn’t matter if the fund has gone down in value.

Here is an example using a fictitious mutual fund.  Assume you own 1,000 shares of the XYZ China Growth Fund and it is down about 10% this year.  The fund company recently announced they are estimating long-term capital gains distributions at the end of December in the amount of $2.81 per share.  At a current share price of $15.00, shareholders will receive taxable distributions equal to 18.73% of their holdings.  On 1,000 shares, worth $15,000, you will pay tax on $2,810, even though your fund value was down $1,667.

What if you were to buy 1000 shares of the same fund today for $15,000?  Again, you would be dealt a taxable capital gains distribution of $2,810 for this year’s tax return.

Not fair, right? That’s because all mutual fund companies are regulated investment companies, and by law they must distribute all of their income by the end of the year.  In complying with this rule, the mutual fund avoids paying tax.  Instead, the shareholder pays the tax on both dividends and capital gains distributions.  If your mutual fund is in a retirement account or a sub-account of a variable annuity, you won’t be affected.

Most equity mutual funds will have sold stocks this year.  And even if their share price is down, they might have net gains (more gains then losses) to distribute.  Sometimes fund managers sell stocks to buy others or to provide cash for liquidations.  When the fund distributes dividends and capital gains, it actually pays them to the shareholder. 

On the ex-dividend date--the date on which the seller, and not the buyer, of a stock will be entitled to a recently announced dividend--the fund price will decrease by the amount of the distribution.  If the shareholder has elected a reinvestment option, then the fund will use the distribution to buy more shares in the shareholder's account, and the market value of the fund position will stay the same.  If the shareholder takes the distribution in cash, the market value of the fund will decrease by the amount of the distribution, but then the account's cash balance will increase by the amount of the distribution.  In both cases the market value of the overall account will stay the same.  But remember, whether the distributions are reinvested or distributed, the shareholder must report them on his or her tax return.

Question:  I own 1,000 shares of a publicly traded stock that I paid $50 per share five years ago.  Today, the stock is trading around $3.00 per share.  I would like to capture my loss, but I don’t want to sell the stock because I think it will recover.  What can I do?

Answer:  You can do a “wash sale.”  Buy an additional 1,000 shares of the stock today.  Wait 31 days and then sell the lot of 1,000 shares you bought five years ago.  It is very important when you or your broker is submitting the trade to make sure that the first lot of 1,000 shares is being sold and not the second, most recent lot of 1,000 shares.  Follow up and double check the trade confirmation that the 1,000 shares you sold were the shares you bought five years ago.  Save the confirmation in case the IRS questions you. You will still own 1,000 shares and you will have captured a $47,000 capital loss.

Kenneth B. Petersen CFP®, EA, MBA, AIFA® is an investment advisor and Principal of Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey.   He welcomes questions that you may have concerning investing, taxes, retirement, or estate planning.  Send your questions to: Ken Petersen, 2340 Garden Road Suite 202, Monterey, CA93940 or email them to ken@montereypw.com.