Despite flat market, many funds will deliver taxable gains
NEW YORK — Never mind that this year has largely been a dud for stocks. A tax bill is still coming for many mutual-fund investors.
Now that December is here, funds are lining up to pass along something called a capital-gains distribution to their shareholders. It's about as appetizing as it sounds.
Investors who hold mutual funds outside a 401(k) or another tax-advantaged account must pay taxes on these distributions, even if they don't sell any shares. And the bills could be big: More than a dozen funds have already said they expect to pass along distributions in coming weeks that are more than 30 percent of their total assets.
Several factors are behind this year's distributions, from home-run stock picks made years ago to the recent surge in corporate takeovers. But first, a reminder on what causes distributions and how they affect investors.
When a fund sells a stock, it records how much it made or lost on it. At the end of the year, it totals the gains it made from trading and distributes those gains to shareholders.
Say you hold a mutual fund whose shares currently trade at $10 each. That fund may distribute $2 per share in capital gains to you at the end of the year. You have to pay taxes on those gains if you hold the fund in a taxable account, even if you didn't sell any shares. Long-term gains generally qualify for lower rates than short-term gains.
The value of your holdings won't normally change as a result of the distribution, which often gets reinvested in the fund. The price of each fund share in this example would drop to $8 when it made the distribution of $2, leaving you with the same $10 per share.
The Fairholme Fund expects to make distributions of $11.55 to $12.35 per share next week. That's equal to about 35 percent of the fund's assets, as of Wednesday, and would dwarf last year's distribution of $3.08 per share.
The main reason for the jump is that AIG did what shareholders hoped it would after Fairholme Fund bought it in 2010 and 2011: It surged. AIG generated more than $2 billion in gains for the fund by June of this year. And when it sold AIG shares, it recorded a big gain.
Another reason for this year's rise in distributions is the explosion in corporate takeovers. Companies are finding it difficult to drum up revenue growth given the still-tepid global economy, so they're buying competitors instead. Others are combining in cross-border deals to lower their tax rates.
At the Jensen Quality Growth Fund, managers expect to pass along distributions of $3.74 per share, which is about 9 percent of its total assets, as of Wednesday. Last year's was $1.63.
Earlier this year, one of its investments, Medtronic, completed its $42.9 billion acquisition of Covidien. The deal created a tax bill. The fund also recorded big gains from sales of its holdings in Automatic Data Processing and Equifax .
The fund took the unusual step of explaining what was behind the distribution to shareholders in a notice on its website and in general conversations, says Dave Mertens, managing director at Jensen Investment Management.
"For the most part, investors understand this is a bit of an anomaly and this is an unusual year," he says.
A third reason for this year's distributions is the continued migration of dollars out of actively managed funds. Investors are flocking instead to the lower costs offered by index funds. When shareholders ask for their money back, fund managers may have to sell some of their investments to raise more cash. That selling means they may have to book more gains.
Here are some other factors to keep in mind as distribution season approaches:
• Only investors in taxable accounts need to care. If all your funds are in an IRA, these distributions have no effect.
• If you're looking to buy a fund, it can pay to wait. When a fund makes a distribution, it goes to all investors regardless of when they entered. Find out on funds' websites when they plan to make distributions and wait until afterward to buy. The flip is also true: If you're planning to sell a fund, do so before the distribution.
• Index funds can be more tax-efficient, but they're not immune. Index funds generally buy and sell less often than actively managed funds, which means fewer opportunities to trigger capital gains. But even index funds and ETFs can pass along distributions. Some indexes are likely to have more turnover than others. A small-cap growth stock index will probably see its member list change more than a total stock-market index.
• Some funds are built to be more tax-efficient. Funds that go by the "tax-managed" label trade less often. They also may avoid stocks that pay dividends because that income is taxable.