Phantom
Gains
By Vita Nelson, editor
The Moneypaper
Don't
buy just before a mutual fund's capital gains distribution. If
you do, you're buying taxable income. Late in the year, mutual
funds often distribute realized gains to shareholders. (Even
in down years, such as 2002, mutual funds may have realized gains
from selling off long-held winners to meet shareholder liquidations.)
Such distributions are taxable, even though investors don't get
to enjoy any gains.
Suppose that among
XYZ Fund holdings are shares of Big Tech that it bought in 1992,
when the stock was selling for $5 per share. And suppose that
in 2002, Big Tech is trading at $30 per share and XYZ unloads
its position to meet the demands of shareholders who want out
of the fund. XYZ Fund would realize a capital gain. And suppose
that throughout the year, XYZ has lots of redemption demands
and sells other winners. In December 2002, the fund would make
a capital gains distribution of $2 per share, reflecting the
profits it has taken.
Now suppose you buy
100 shares of XYZ Fund in November 2002, paying $15 per share.
In December, you are credited with the $200 capital gains distribution
($2 per share times 100 shares). The price of XYZ shares falls
$2 to $13 after the distribution. As a result, you owe income
tax on the $200 capital gain distribution, even though you enjoyed
none of the benefits. That's true even if you reinvest the distribution
and don't receive any cash. Instead, you would have been better
off waiting until after XYZ's distribution and buying at $13
per share. Check into the fund's distribution schedule and buy
afterwards at a lower price.
Better yet, favor fax-efficient
funds that try to avoid capital gains distributions. Such funds
try to offset gains and losses, and tend to be more stable because
of their low turnover. For example, the MP 63 Fund (DRIPX) was
not forced by shareholder redemptions to sell shares, and expects
no capital gains distributions in December, when it will pay
dividends of less than 10 cents per share.
Editor's Note: Vita
Nelson is editor of The Moneypaper, 555 Theodore Fremd
Ave., Suite B-103, Rye, NY 10580, 1 year, 12 issues, $99. The
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