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Mutual Fund Tax Bills Rise Sharply: How You Can Avoid Them

The free lunch is over.

Russel Kinnel, 02/27/2006

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No doubt about it, mutual funds are getting more taxing.

Taxable capital gains distributions doubled in 2005 versus 2004. The average diversified U.S. equity fund distributed 3.32% of its assets as capital gains last year compared with 1.67% in 2004. The story is much the same if you consider foreign and sector funds: The average distribution was 2.93% versus 1.46%. For both groups, those 2004 figures were also up sharply from 2003 when the average distribution was less than half a percent.

The number of funds making capital gains distributions also rose. Among diversified U.S. equity funds, the figure went from 64% to 74%. Among all stock funds it surged from 69% to 79%.

The reason capital gains spiked is that 2005 was the third positive year in a row for most equity markets. Moreover, small caps have been on a five-year tear and therefore now hold very few positions at sizable losses. In addition, the bear market is now fading into the distance as the market climbs higher.

The upshot is that you and your clients had better start paying attention to tax issues on mutual fund investments if you haven't before. The market, particularly small caps, has already enjoyed solid gains so far in 2006. Even if the market finishes the year flat, however, you'd be wise to build a tax strategy.

Tacks to Try

Mutual funds have to distribute all the capital gains they realize (after subtracting capital losses and tax-loss carryforwards). However, those that use a tax-aware strategy to reduce distributions have proved quite successful at minimizing capitals gains distributions.

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