Year-end mutual fund tax planning

Kenneth B Peterson for the Monterey Herald writes: I nvestment pundits are warning investors about large mutual fund distributions this year, so if you own or plan to buy a mutual fund this month, be aware. According to Morningstar, American Funds will pay distributions of between 5 and 8 percent of the share price on three of its funds, and three Vanguard funds will pay out about 10 percent of their share price.

As regulated investment companies, mutual funds must distribute all of their income by the end of the year to avoid paying income tax. If your fund is not in a retirement account, you pay tax on your share of dividends and capital gains distributions. Equity mutual fund managers sell stocks to reposition their portfolios or to provide cash for liquidations.

When a fund manager sells a stock for more than the purchase price the fund realizes a capital gain and then distributes the gain along with any dividends to you before Dec. 31. You in turn report these gains and dividends on your tax return.

When the fund distributes dividends and capital gains, it actually pays them to you and on the day the dividend and capital gain distribution is declared the fund price will decrease by the amount of the distribution.

If you have elected a reinvestment option, then the fund will use the distribution to buy more shares, and the market value of your account will stay the same. If you take the distribution in cash, the market value will decrease by the amount of the distribution. But in either case — whether the distributions are reinvested or distributed — you must report them on your tax return.

What you need to know:

1. If your fund is worth less then what you paid for it and is forecasting significant capital gains and/or dividend distributions, consider selling it before the record date. Review the fund and the reasons you own it. Don't sell it just for tax reasons. If you do decide to sell it you will have a deductible capital loss and you can always buy it back again after the record date.

If you do buy it back, wait at least 31 days from the date of sale to avoid the "wash sale" rules. Or, you could buy a similar fund without waiting.

2. If you are thinking about buying a mutual fund before the end of the year, call the fund company and find out if they are forecasting taxable distributions. Include this information in your decision-making process. But don't let the threat of taxes alone stop you from making your purchase. You could be worse off if you miss out on a year-end rally in the fund's share price.

3. Never make your investment decisions based solely on the tax consequences. But do consider the tax consequences in your investment plan.

4. Remember that some dividends and all long-term capital gains qualify for a maximum 20 percent federal tax rate and may be subject to a 3.8 percent additional net investment income tax, depending on your income level. If you buy shares now and pay tax on a distribution that you reinvest in more shares, you will acquire a cost basis in those shares that won't be taxed later at a possible higher rate.