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Some mutual fund investors may get hit with a tax bill this month (as seen in the Pittsburgh Post Gazette)

Some mutual fund investors could be in for an unpleasant surprise this month when they get hit with a tax bill for mutual funds in their portfolios that had either flat returns or may have even lost money this year.

December is when mutual fund managers distribute taxable gains to shareholders, and despite flat returns in the stock market this year, mutual fund managers are likely to distribute rather large taxable gains to shareholders, said Jonathan Bernstein, a senior research analyst at Hefren-Tillotson, Inc., Downtown.

“There’s a little bit of disconnect between mutual fund mechanics and the returns on paper,” Mr. Bernstein said.

Mutual funds distributing capital gains to shareholders is nothing new. When mutual fund managers sell holdings from a fund, that transaction results in a gain or a loss. Each year, funds must tally up the total amount of gains and losses. If there is a net gain they are required to pass the gain on to the funds shareholders.

What’s different this year is that markets on the whole have seen pretty low returns, or even negative returns. Yet there are still going to be a lot of distributions. Mr. Bernstein said this may catch a lot of mutual fund investors off guard who may associate big distributions with big gains in the stock market.

But why are distributions likely to be higher this tax year?

“Coming out of the financial crisis, a lot of mutual funds had losses they could carry forward to offset gains they were taking in their portfolios,” Mr. Bernstein said.

“Those losses minimized capital gains distributions from 2009 to 2012. Then in 2013, capital gains picked up, and then last year, in 2014, the gains almost reached the peak level of distributions seen in 2007.

“With stocks up considerably since 2009, and a few periods since then of down markets, there are a lot of holdings with gains in the mutual fund portfolios,” he said. “Consequently, when mutual fund managers are making changes to a portfolio now, they tend to realize gains and have no or little losses to offset to gains. This results in these larger taxable gain distributions.”

These taxable distributions only apply to investors who hold mutual funds in a taxable account. The gains must be reported on an individuals income tax return. However, if an investor holds mutual funds in a tax-deferred retirement account, such as an IRA or 401(k), the capital gains distributions are not an issue.

Thomas Walsh, a portfolio manager at Palisades Hudson Financial Group in Scarsdale, N.Y., said while 2015 has seen a slowdown in the recent bull market, mutual funds hope to avoid selling highly appreciated stocks to meet shareholder redemptions.

“When a trending fund has attracted a lot of investment from performance-chasing investors and subsequently faces massive shareholder redemptions as market sentiment changes, a red flag raises that the fund will have a large year-end distribution,” Mr. Walsh said.

“The simplest way to avoid capital gains distributions is not to be subject to them in the first place, he said. Call your fund company in early November, before most funds make their year-end distributions, and ask whether it can estimate what the distributions will be. Most companies will provide estimates, as well as post this information on their website.”

Mr. Bernstein also stressed that now is a good time for investors to evaluate their holdings.

“Do you have holdings with losses or small gains that will be paying large capital gain distributions? If so, those may be good candidates to sell before the distribution is made, assuming the distribution will cause more of a tax hit than selling the fund overall.”

It’s a good idea to look at the total gain you might have on the position altogether, he said.

“If you’ve held something for a long time you might have doubled your money in it, Mr. Bernstein said. If its paying out a 10 percent gain this year, thats probably not a good reason to sell it. You might avoid the 10 percent gain, but then you would pay taxes on a 100 percent return on the investment.”

Tim Grant: tgrant@post-gazette.com or 412-263-1591.

Investment Advisory Team

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