Uncle Sam's Surprise

Thursday, May 07, 2009

Columns - The Wall Street Princess

Feel Like Having A Nasty Surprise From Uncle Sam?

Mutual fund holders will soon be saddled with a heavy tax bill for capital gains. Your next step?

Investors may be saying good riddance to 2008, one of the worst years on record for stocks. But the pain may not to end there: Despite posting double-digit losses, many funds are saddling investors with a hefty tax bill, too. Under IRS rules, mutual funds are required to distribute capital gains and dividends to shareholders, and investors may owe taxes on distributing even if they don't sell their shares. Analysts don't expect 2008 capital gains to be as high as the record $393 billion paid out in 2007. But investors could still be in for a "double whammy" when they get their year-end statements, says Tom Roseen, senior analyst at fund tracker Lipper.

Among the worst offenders: foreign stock funds. Many of these funds soared in recent years, creating big gains that are just now being passed on to shareholders. Oppenheimer's Developing Markets fund, for instance, paid $8.32 a share in 2008 capital gains, 36 percent of the fund's net assets (as of early December). A spokesperson for Oppenheimer says the fund was restructured under a new manager and that the moves would have "significant benefit" for shareholders. Still, the tax bite stings for a fund that lost nearly 51 percent through November.

Part of the problem is that managers generally don't run their funds for tax efficiency, says Christine Benz, director of personal finance for Morningstar. Most focus on buying and selling the best stocks, regardless of the tax consequences. And their bonuses are usually tied to pretax performance, giving them scant incentive to cut the tax bill. "We don't let the tax tail wag the dog," says Lee Harper, vice president of Southeastern Asset Management, which runs the Longleaf funds.

Some funds are managed to keep the IRS away- and investors may want to switch if they're getting walloped. Vanguard and Eaton Vance offer a variety of tax-managed funds, which use a buy-and-hold strategy to keep "realized" capital gains low. T. Rowe Price also offers such funds and has taken other steps to cut the tax hit, says Treasurer Greg Hinkle. The firm estimates it will pay out $3 billion in 2007.

The silver lining to all this? Many funds are carrying big losses from the market meltdown and should be able to use them to offset future capital gains, says Roseen. That decreases the chances that the Uncle Sam will come calling after another year. To Avoid the Trap Next Year .... Hold mutual funds with high capital gains in tax-deferred accounts, such as IRAs and 401(k)s. Sell your money-losing funds before they pay out capital gains or dividends. Consider switching into an exchange-traded fund or an index fund. Both track an index like the S&P 500 and pay out minimal capital gains.

(PPI says thanks to Daren Fonda)