Mutual Fund Owners Eyeing Big Tax Hit

The end of the year is coming - a time when mutual fund companies distribute capital gains. This year mutual fund shareholders may suffer with huge capital gains taxes despite significant losses in their portfolios. Although stocks have underperformed, many unsuspecting investors will likely see gains in their holdings as panicked fund managers have sold equities in order to pay out their shareholders. This could leave you with a substantial tax bite because capital gains taxes will be collected on stocks which rose prior to the recent free fall. What can you do before you are invited to pay taxes on someone else's gains?

First off, you must find out when distributions will take place. If gains have not been disbursed, consider selling your fund before the tax is assessed. Move your money into exchange-traded funds (ETFs) that have historically limited the capital gains impact on their holdings (they employ a steady, buy-and-hold strategy). Secondly, delay new fund purchases until next year. "If you're going to buy, wait until the fund distributes capital gains before you get in so you don't get taxed on a fund you have not benefited from," advises our expert Nathan Threebes. He further explains: "When investing in mutual funds your assessment of performance should be paired with tax consequences. Don't forget to look for the funds with low turnover ratio, something in 5%-50% range. Turnover ratio measures how often the fund buys and sells its holdings. A ratio of 50% means that the fund sells half of its portfolio, on average, once a year. Funds with low turnover ratios are least likely to generate large taxable capital gains".

If you are selling, shed smaller gains if you have no losers to sell. For instance, if you purchased 100 shares at $10 then added 100 more at $15 - and the stock has risen to $20 - sell the shares you purchased at $15 to limit your taxable gains. This requires accurate record-keeping as to when you purchased and how much you paid. Additionally, consider waiting to sell until after the one-year holding period because long-term capital gains tax rate is lower (a 5% reduction thanks to recent tax laws).