Some mutual fund investors twice burned

Star Tribune (Minneapolis) (MCT) - This year has been one that most every investor would love to forget. The Dow is down more than 40 percent from its October 2007 peak and 99.7 percent of U.S. equity mutual funds are in the red this year.

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That their portfolios are down double-digits is no surprise by now. What may shock _ and infuriate _ investors is that, despite a brutal year for stocks, some will owe hefty capital gains taxes on their losing funds come April.

"I think it's going to be a situation like 2000, where you had people that had big, built-up gains in mutual funds that are seeing their portfolio values fall and they get hit with a gains distribution _ a double zinger," said Scott Oeth, a principal of Cahill Financial Advisors in Edina, Minn.

Mutual funds around the country are beginning to post capital gains estimates on their Web sites. People whose sole investments are in 401(k)s and IRAs don't need to worry, however; these taxes are paid only by investors in mutual funds held in taxable accounts.

Blame the tax bill on nervous investors who withdrew a record $110.3 billion from the stock market as of Oct. 31, according to Morningstar Inc. The massive redemptions forced some mutual fund managers to sell positions in order to hand investors their cash. Some of those positions may have been held for years, performed well and earned major profits during that period. The Internal Revenue Service requires taxes to be paid on the income generated from a sale, whether a fund is having an off year or not.

Some asset classes are more likely to trigger gains than others this year. For instance, investors in international and commodities funds _ high-flying categories in 2007 that fell back to Earth this year _ tend to have a lot of unrealized capital gains.

Knowing capital gains distributions in a down year would be tough for investors to stomach, some portfolio managers have done all they could to avoid one.

Take the Leuthold Core Investment Fund. Selling the fund's industrial metals stocks this year triggered gains, because the category gained 400 to 500 percent in the past five or so years, according to co-portfolio manager Eric Bjorgen.

"As we came toward the end of the year, we realized 'Oh, boy, here we are in a down year with the potential for a big capital gains distribution requirement.'" So they took a look at their holdings and offset gains by selling losers in the oil and gas industry and finding similar stocks to buy. "Our goal was basically to take an admittedly painful year in terms of performance and be able to neutralize our capital gains to bring them down to zero so we didn't shock investors," Bjorgen said.

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Bob Markman of Markman Capital Management hasn't had a capital gains distribution since 2002, and has no sympathy for managers expecting one this year.

"When there's been losses in every single market segment ... losses that ate up one, two, three years' worth of gains in some circumstances, for a manager to not take those losses and harvest those losses to offset any capital gains is just an indication of laziness and lack of fiduciary responsibility," he said. "A manager who wasn't doing this and wasn't offsetting gains with those losses should update their resume and make sure their lawyer's on speed-dial."

Some fund managers argue that performance, not minimizing taxes, is their No. 1 priority.

"While capital gains implications are considered by RiverSource portfolio managers, primarily investment decisions are made with a long-term horizon," spokesman Charlie Keller said. "It wouldn't be prudent to allow a short-term tax implication to eliminate potentially a larger gain over the long term." RiverSource Investments, a subsidiary of Ameriprise Financial, expects its capital gains estimates shortly.

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Sit Mutual Funds, a manager with a buy-and-hold approach, estimates that two of its funds _ the Sit Dividend Growth Fund and the Sit Developing Markets Growth Fund _ will generate long-term capital gains distributions. Roger Sit, chief investment officer of Sit Mutual Funds, acknowledges that he could have flipped the portfolios, but he doesn't think that would have been wise.

"When the market is oversold ... the last thing you want to do is go 100 percent into cash" and sell high-quality stocks, he said.

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There are strategies that can be employed to minimize or avoid a big gains-related tax bill, but investors must act quickly; most funds make their capital gains distributions in December, but others will distribute any day now.

One way for most individuals to offset capital gains would be by selling losing investments by Dec. 31. "I'm willing to bet (that clients) have stocks that have fallen in value for the past few months," said Todd Koch, a certified public accountant with John A. Knutson and Co. in Falcon Heights, Minn.

Tax law allows individuals to write off their capital gains with losses. Capital losses can be written off against capital gains. If losses exceed gains, as much as $3,000 can offset other income. Unused losses can be carried over from year to year.

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Another workaround used by many financial advisers is to get out of the fund before it makes its distribution. Only shareholders of record on the day of distribution owe capital gains, even if you've been holding the fund for years. On the flip side, if you buy a fund the day before it makes its distribution, you'll be on the hook for paying tax, which is why advisers suggest that investors take care when buying mutual funds toward the end of the year.

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In some instances, Oeth, the certified financial planner, will have a client sell out of a mutual fund with an expected gain and put the client in a similar, but more tax-efficient, investment such as an exchange-traded fund or index fund that invests in the same type of stocks as their former mutual fund. This is a move some clients are finding attractive even if they don't have major gains, motivated by the belief that the current long-term capital gains rate of 15 percent for most taxpayers will most likely rise in the future.

Investors who are satisfied with their portfolios may decide that timing the distribution is not worth the hassle, or that being out of a volatile market for even a few days could mean missing out on gains. But it's a good idea to learn about a gain sooner, not later, to prepare to pay Uncle Sam.

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© 2008, Star Tribune (Minneapolis)