Tax Bills for Fundholders on the Rise
Capital gains payouts soared in 2007.
Capital gains payouts soared in 2007.
You may be in the red for 2008, but you probably will be paying capital gains taxes come April. Capital gains payouts in 2007 rose for the fourth straight year.
For 2007, the average U.S. equity fund paid out 6.89% of year-end net asset value. That compares with 4.17% of assets in 2006, 3.32% in 2005, and 1.67% in 2004. For international equity, the average payout grew to 7.49% compared with 4.98% in 2006. For balanced funds the payout jumped to 3.0% from 1.95%. For taxable-bond funds, the payout rose to 0.20% from 0.12%. (The main tax bill for holders of taxable bonds and bond funds is on the income, which is taxed at a higher rate than long-term capital gains.)
In terms of how many funds made a payout of any kind, the figure was 75% for U.S. equity, 83% for foreign equity, and 83% for balanced.
Why the surge? The main reason is simply that capital gains payouts reflect gains accumulated over previous years. In 2003 and 2004, many funds had bear market losses to offset their more recent gains. By now those charge-offs are largely gone and most funds have to pay out capital gains when they turn over their now-profitable portfolio. If the downturn we saw in January gains steam, the trend would likely reverse.
Shouldn't investors want capital gains distributions? I get that question a lot, and the answer is no. There's a big difference between appreciation and capital gains distributions. A fund could appreciate a lot and not make a payout. That would allow you to continue compounding your returns and at the same time postpone your tax bill in the future when money is worth less. (You'd rather have $200 today than a promise for $200 in 10 years.) In addition, a fund could give you a big tax bill even though you haven't made a dime, because capital gains are based on gains that the fund realized and distributed to all shareholders equally regardless of their cost basis.
I've included a table of the funds making the biggest capital gains. There are some jaw droppers, including an institutional fund from the Boston Company where redemptions meant it had to realize gains and there were fewer shareholders to which to give them. Also noteworthy was Harbor Large Cap Value (HAVLX). The fund switched subadvisors from Armstrong Shaw to Cohen & Steers, and it looks like Cohen completely changed over the portfolio because the fund paid out 53% of its year-end NAV. For perspective, that's more than it gained over the previous four years.
Funds Paying Out the Highest Percentage of NAV in Capital Gains in 2007 | |||
Category | Year-End NAV | % of NAV Distributed in CG in 2007* | |
The Boston Co Intl SmCap | Foreign Small/Mid Value | 1.24 | 94.67 |
Delaware Pool Mid-C GrEq | Mid-Cap Growth | 0.92 | 77.31 |
Roxbury Mid Cap Inv | Mid-Cap Growth | 1.58 | 71.31 |
Goldman Sachs StrSmCpValA (GSATX) | Small Value | 3.64 | 68.79 |
Delaware Pool SmCp Gr Eq | Mid-Cap Growth | 5.79 | 65.37 |
Nicholas-Apple Intl Gr I | Foreign Large Growth | 9.26 | 64.80 |
Integrity Small Cap Gro A (ICPAX) | Mid-Cap Growth | 3.66 | 58.47 |
Prov Inv Couns Sm Cp Gr | Small Growth | 9.34 | 55.31 |
Harbor LargeCap Value Ins (HAVLX) | Large Value | 9.44 | 52.81 |
JHT Real Est Sec Tr I | Specialty-Real Estate | 12.4 | 51.33 |
Data as of 1-31-08. *Oldest share class only. |
How to Limit Cap Gains Payouts in 2008
1. Max out on tax-sheltered accounts. Taxable distributions are not a problem for 401(k)s, 403(b)s, IRAs, and 529s, so invest as much as the law will allow before you put money in your taxable accounts.
2. Consider tax-managed funds for your taxable accounts. Tax-managed funds, such as those offered by Vanguard, do a great job of avoiding making distributions because they realize losses on some holdings when they have to realize gains on others. After taxes are figured in, these funds generally put up superior returns.
3. Consider exchange-traded funds. ETFs don't have all the strategies that are available to tax-managed funds but they do have some unique features that help reduce their tax bill. Just make sure you've chosen one that is diversified, has low costs, and has low turnover.
4. Don't buy funds that have had huge returns over the past three years. Buy a fund with huge gains and you're going to get a huge tax bill regardless of whether you make any money yourself. So, tread carefully in hot areas. At the moment, foreign funds, particularly emerging-markets funds, are among those brimming with the biggest gains. Find a specific funds' potential capital gains exposure on Morningstar.com by clicking on its Tax Analysis tab on the left-hand side of the page. This will clue you in to whether a fund has built up a lot of gains.
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