Although MsFiscallyFit.com promotes long-term investing and believes it is difficult to time the market's "ups and downs", there is one timing issue that
is very important when you buy mutual funds. Before you buy a mutual fund, find out when the fund is going to make their next distribution of capital gains. Why is this important? If you are not
careful, you can end up paying taxes on income you never received (that is good for Uncle Sam, but bad for you). As you are aware, a mutual fund is a pool of
different investments and the fund manager decides when to buy and sell an investment. You, as one of the mutual fund shareholders, participate in the net gains and losses of the fund. Throughout the year
all the long-term and short-term net capital gains are accumulated and distributed to all the shareholders. Capital gain distributions are usually made once a year – typically near the end of the calendar year in
December. Here's the catch – all accumulated annual capital gains are distributed to the existing shareholders at the time of distribution, no matter how long you've been in the mutual fund – the gains are NOT
prorated based on how long you've been in the fund. So even if you weren't around long enough to participate in all the profits generated throughout the year, you will have to pay taxes on whatever capital gains
are distributed to you -- ugh, more taxes! Here's an example of what could happen to you if you purchase a mutual fund right before they distribute capital gains: Let's say on December 1st you invested
$5,000 into a stock mutual fund that has performed extremely well during the year, but has a very high turnover rate. Throughout the year, the fund has taken a lot of profits by selling stocks and has generated
short–term profits representing 20% of the value of the mutual fund. On December 15th
the mutual fund distributes those profits to its existing shareholders, who in turn must pay taxes on the reported capital gains. So in this example, you would be required to pay taxes on a $1,000 gain ($5,000 x 20%). If your taxable rate is 30%, you could pay an extra $300 ($1,000 x 30%) on gains you never received. Because you invested in the mutual fund toward the end of the year, you did not participate in the appreciation of the fund's net asset value (NAV) during the year. But unfortunately, you did pay taxes on the reported capital gains. The cold hard facts are you essentially paid extra money for the mutual fund – an extra $300. Yes, maybe unfair, but that is the way mutual funds work.
Your best defense against paying extra taxes is to buy a mutual fund right after they distribute the capital gains. Although, this may not always be the best time, because of the performance of the mutual fund
at that moment, you should at least be aware of the capital gains distribution date and try to work around it. Whenever you call the mutual fund to get a copy of the prospectus and annual report, ask the customer
service representative for the capital gains distribution date and make note of it. Additionally, some funds offer that information on their web site. Many unsuspecting investors each year pay additional taxes
that could have been avoided had they known about the capital gains distribution trap. We at MsFiscallyFit.com are committed to increasing your knowledge so that you MAXIMIZE all your investment dollars. |
