Should your favorite mutual fund hit you with a hefty capital gains distribution in the next few weeks, don't whine or worry. Turn it to some positive use.
Now there's an offbeat idea in this age of being aggrieved pass up a chance to protest. It calls to mind the corny but cogent aphorism, "When life hands you a lemon, make lemonade."
For a suggestion on how to follow that advice with those oh-so-taxable year-end gains distributions, we turn to Sheldon Jacobs, publisher of the No-Load Fund Investor newsletter in New York.
"Distributions will be heavy this month and next," Jacobs says in the November issue of the letter, noting that many funds sold stocks amid the storms of the 2000 market, realizing big gains built up in previous years.
The rules say that the funds must pass through any net gains to shareholders by year-end.
Except in tax-deferred setups such as employer-sponsored 401(k) plans and individual retirement accounts, investors will face a tax bill on these gains even if they automatically reinvest their distributions in new fund shares.
Here's where Jacobs' positive response kicks in: Instead of having this year's gain reinvested, as most investors routinely do, instruct your fund to pay it to you in cash.
"A phone call is generally sufficient," Jacobs says. "The tax on the distribution is the same whichever alternative you choose."
Once you have received your check or, perhaps more conveniently, had the distribution paid into your money-market fund, there are several useful things you can do with it.
Avenues for cash
The first to consider is rebalancing, or bringing the asset allocation of your investments back closer to your original intentions. Let's say you started out five years ago with a plan to keep 65 percent of your money in stock funds and 35 percent in money funds. Now, after stocks' great bull run of 1995 through early this year, the weighting of your holdings is more like 80-20.
To this point you've resisted rebalancing out of inertia and an unwillingness to deal with the tax consequences of shifting money out of stocks. Well, the year-end distribution gives you a sum to work with that's going to be taxed anyway.
It's probably not the precise amount that your asset allocation model calls for.
Unless you have some fiduciary committee looking over your shoulder, though, that's not so important. A partial rebalancing may serve you much better than no rebalancing at all.
That basic idea opens up other possibilities. Let's say I have accumulated a good-sized position in a fund that set a dazzling pace in years gone by, but has now slowed and grown too big for my taste.
I can take the distribution and put it in a newer, smaller fund I've had my eye on, starting to diversify out of the old fund without incurring any taxes I wouldn't have had to pay anyway.
Added bonus: The paperwork will be minimal, and I won't have to trouble myself or run up time on my accountant's meter deciding which of several possible tax treatments to use if I sold part of my shares in the old fund. Unlike many other capital gains, fund distributions are simple to account for on your tax return.
Not tax money
This money, I remind myself, is not for spending. Another thing I wouldn't do with the distribution proceeds, unless my finances left me no choice: Set the money aside to pay taxes.
I realize, it makes no difference from which of my accounts I write the check to Uncle Sam.
In practice, however, I am not a money-management automaton. Many a distraction may arise between the moment a dollar gets into my cash flow and the time when it's safely diverted to savings and investment. If I can leave my investment accounts undisturbed and pay the taxes out of current funds,
I forestall the possibility that I won't get around to making up the difference in my nest egg.
The idea behind all these tactics is to prevent taxes from disrupting your investment plan any more than necessary. Going with the flow this way may not make gains distributions seem like a blessing instead of a burden, but it can take some of the sting out.
Chet Currier is a columnist for Bloomberg News.
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