A hurricane watch has been posted for the rest of 2000 in Mutual Fund Land.
A disturbance of potentially large proportions is brewing over the always-touchy subject of year-end capital gains distributions.
The elements include a huge buildup of gains left over from the roaring 1990s, erratic markets that have made little net progress in 2000, and a dash of politics. Imagine a forecaster studying the scene and muttering, "This has all the makings of a perfect storm."
Some of the story is familiar stuff. We've had a commotion every year since the mid-1990s over capital gains distributions payouts that funds must make to their investors of the net profits from securities the managers sold during the year.
Shareholders who own their funds in traditional taxable accounts have to pay federal income taxes on these distributions, at capital gains rates of up to 20 percent, and often state taxes, too. They can't escape the tax bill even if they automatically reinvest the distributions in new fund shares, as nine out of 10 investors do.
This is an unpopular setup, because it hits investors with tax obligations of unpredictable size even when they stick religiously with a buy-and-hold strategy.
The situation looks even more fractious than usual this year. Many funds accumulated big gains over the past five years and especially in 1999, when the Nasdaq Composite Index comprising many prominent growth stocks soared 86 percent.
This year, by contrast, the market averages have gone nowhere; the Nasdaq index is down slightly. In a year of wide swings for computer and telecommunications stocks in particular, many fund managers have shuffled their holdings, turning paper profits into realized gains.
This adds up to a formula for big distributions in a year of small returns. It's conceivable, if not likely, that investors in some funds will wind up paying taxes bigger than the investment returns they have seen during the year.
Arrrgh! As fate would have it, all this comes just as regulators are considering new rules aimed at more disclosure of the effects of taxes on funds' reported investment returns. So the issue is already tracking on the radar screens of Congress and the Securities and Exchange Commission.
No wonder the forecast calls for high winds. But before you do something drastic such as fleeing to high ground, some words of calm are in order.
When you keep your eye on the big picture, capital gains distributions don't look as menacing as they are often portrayed. If a fund you bought yesterday for $10 pays a $2 distribution today, you do owe, say, 40 cents in taxes on gains you haven't attained. But after you reinvest the $2 in fund shares, the cost basis of your investment goes up to $12.
If you sell a year from now at $12, you'll owe no further taxes at that time. If you sell right now, you realize a loss that offsets the gain from the distribution for tax purposes.
Thus the damage from fund gains distributions isn't a matter of more taxes paid, just taxes paid sooner. In other words, you lose the benefits that tax deferral can contribute to the compounding of your money.
This can add up over time. Don't think for a moment, though, that deferring taxes means avoiding them. If you hold your funds in a tax-deferred retirement account, you're shielded from any current tax obligation on distributions.
But consider what happens down the road if, say, you die before you withdraw any of your money and your heirs cash in the account. There'll be income taxes due on every penny at ordinary income rates let's say 28 percent to Uncle Sam and another 7 percent in state and local taxes.
Perhaps the storm this time will teach us something useful.
It might even stir up some support for modernizing the tax laws covering funds, allowing all investors to defer taxes on reinvested distributions.
Chet Currier is a columnist for Bloomberg News.
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