Beware Tax Surprises in Mutual Funds

Continued strength in small-cap value stocks could lead to a return of an old nuisance: capital-gains distributions. Real-estate and precious-metals sector funds are also a threat to make distributions.

While most large-cap and growth-style funds are still in the red for the past three years, many small-value funds and those focused on REITs and gold now have double-digit annualized returns.

As a result, it’s likely that quite a few will be making capital-gains distributions in December. If you get capital gains distributions to a fund you hold in a taxable account, you’ll have to pay taxes on that distribution come April. (For tax-sheltered accounts like 401(k)s and IRAs, distributions aren’t a problem.)

To come up with a list of likely distribution candidates, I screened for funds with relatively high turnover, double-digit annualized three-year returns, and potential capital-gains exposure of 15%. Among the funds that popped up were  RS Partners (RSPFX), a fund that’s working on its fifth straight year of positive returns, including an impressive 45% gain so far this year.  Boston Partners Small Cap Value II (BPSCX),  Skyline Special Equities (SKSEX),  American Century Small Cap Value (ASVIX), and  Wasatch Small Cap Value (WMCVX) also appear likely to make distributions this year.

The screen isn’t a perfect predictor, however. Only the fund companies know how much of their potential capital gains has actually been realized. Moreover, the fiscal year doesn’t end until October, so the direction of the market and additional trades by management can make a big change in what’s distributed. Many of the larger fund companies post distribution estimates on their sites in October and November.

What Should You Do?
If you have a taxable account in which you own a fund likely to distribute gains, check with the fund company to see if they have an estimate yet. If they are expecting to make a distribution, take a look at your other holdings to see if there are some losses you can harvest to offset the likely gains you’ll get. Before you pull the trigger, though, check in with your accountant.

If you are considering buying a fund that’s had a good three-year run, check with the fund company to see when they’ll have an estimate of gains. If you can’t get an estimate or the firm is estimating they will make a sizable distribution, hold off. You might want to wait until the fund makes its distribution or comes out with an estimate that they will have no gains or very little gains to distribute.

A third option would be to buy a different fund that you like as much as your first choice but that doesn’t have a potential distribution hanging over it.