First, an Awful Year for Mutual Funds. Now, the Tax Bill.
The New York Times
Published: Jan 11, 2009
MOST mutual fund investors endured horrendous losses in 2008, but the pain may not be over yet. After seeing their portfolios’ values melt away like snowmen in the sun, many investors still need to pay taxes on their funds’ dividends.
“People have a feeling they have been ambushed” when this happens, said Michael Stolper, head of Stolper & Company, an investment manager in San Diego. “It’s counterintuitive. When the market is down big like this, it doesn’t seem logical or reasonable or fair.”
Nevertheless, many people will soon be receiving Form 1099s showing that they have taxable income from the dividends paid by their mutual funds.
When markets plunged in the fall, many investors rushed to redeem shares, causing fund managers to sell some holdings to raise cash to make redemptions. And some managers had already sold some holdings and currency contracts. Whatever the reason for the sales, many resulted in capital gains.
Mutual funds are legally classified as pass-through entities, meaning they must pass along any net realized capital gains to shareholders as dividends. But most fund investors choose to have their dividends reinvested, and if they look only at the net value on their statements, the dividends paid may have escaped their notice. There is no current tax liability if the holding is in an I.R.A. or a tax-deferred retirement account like a 401(k), but if shares are held in a regular account, dividends are taxable.
Christine Benz, director of personal financial planning at Morningstar in Chicago, said certain fund categories — notably those that specialize in Asian and developing markets — were more vulnerable than others.
Morningstar does not have a compendium of funds that made high distributions to shareholders in 2008, Ms. Benz said. But some examples that have attracted notice include Oppenheimer Developing Markets, which paid out $8.88 a share on Dec. 8, more than 35 percent of its net asset value just before the distribution. (The fund, by the way, was down 48 percent for 2008.) Others with high distributions included Vanguard Precious Metals and Mining, at almost 18 percent of net asset value; Tweedy Browne Global Value, about 15 percent; Tweedy Browne Value, 13 percent; and Dodge & Cox International, more than 10 percent.
If your nest egg has shrunk, you probably won’t be happy to pay capital gains tax. But at least taxes on capital gains and most dividends — those labeled “qualified” on the 1099 — are now low by historical standards. For most shareholders, the rate is 15 percent, and some will escape the tax entirely.
On 2008 returns, taxpayers in the regular 10 percent and 15 percent brackets will not be subject to capital gains taxes. That means taxable income for single filers below $32,550 and for married couples filing jointly below $65,100.
Mark Luscombe, a lawyer and accountant who is principal federal tax analyst for CCH, which publishes books and software for tax professionals, said that some people in the upper brackets would also escape the tax on their mutual fund dividends because they had capital losses on sales of other securities that would offset the fund income. Capital gains and losses are netted on tax returns, and if the result is a net capital loss, up to $3,000 can be taken against ordinary income and the rest carried forward to future years.
Mutual funds that have a net loss are not allowed to pass the loss on to shareholders as they do gains. But they, too, can carry the loss forward to offset gains in future years. Therein lies an opportunity, Mr. Stolper said.
“An embedded loss means shareholders can get a free ride back up the hill,” he said. “Everyone has this fear of buying now. There is a lot of cash, a lot of negativism. This is typically when markets begin to climb back up.”
Ms. Benz said two fund categories that “have big losses on their books” were large-cap growth funds and technology funds, some of which never recovered fully from their losses of 2000-2.
One lesson investors can learn from 2008, she said, is to consider holding income-producing funds in tax-deferred retirement accounts. The income can grow tax-free until retirement, when distributions are taxed at regular rates. For taxable accounts, she suggested index funds — which typically have very low turnover and thus aren’t likely to spring gains surprises — or tax-managed funds. The Vanguard 500 Index fund had turnover of less than 5 percent last year.
She cautioned, however, that buyers should consider “investment merits ahead of taxes,” adding that taxes “are a wild card,” especially now with an economic crisis and an incoming administration and Congress.
If you sold fund holdings last year, Mr. Luscombe said, you should check past records of reinvested dividends. That could cut the tax liability because reinvested dividends become part of the cost basis. Say you initially invested $5,000 and over the years received 1099s reporting dividends and capital gains totaling $1,500, and, of course, paid the tax. Then, last year, you sold the holding for $8,000. The taxable gain is $1,500, not $3,000, so at least you won’t be taxed twice on the fund’s gains.
© The New York Times. All rights reserved. This article originally appeared in The New York Times.
Services »
