Would You Like Taxes with That?

The Wall Street Journal recently revisited one of the main differences between mutual funds and ETFs – capital gains distributions.

In the article, Fund Investors Face Risk of Tax Hit Despite Losses, the Journal points out that despite a year in which the average U.S. diverisified stock fund is down 33%, some investors will have to pay hefty tax bills on their losing funds anyway.

Why is that?  Mutual funds distribute net capital gains to remaining investors towards the end of each year.  The payments are typically taxable if held in a taxable account.

How could there be any gains in a year like this one?  Capital gains happen when fund managers sell stocks at a price higher than when the original investment was made which could have happened several years ago.  There has been a lot of selling this year as investors have swamped managers with redemption requests and the funds have scrambled to raise cash to meet those demands.

The irony is that the redeeming shareholders won’t see the capital gains distributions – just the shareholders who decided to stick with the fund.

Which funds are likely to hit investors with a tax bill?  Probably most of them.  According to the Journal article, the T. Rowe Price Group expects 42 funds to make distributions this year compared to 50 last year.

How big can the distribution be?  Again from the Journal article, Oppenheimer’s Developing Markets fund expects to distribute a gain of $7.20 or almost 20% of net asset value.

Is it too late to avoid getting stuck with the tax bill? There’s still time to act, but to be safe, move before the end of November.  To avoid missing out on any upside movement in the market, swap out your mutual fund holdings for exchange traded funds – see the ETF Directory for a complete listing by type.

Not sure which ETF to choose? Then just go with Vanguard’s Total World Stock Index ETF (VT) – you’ll get instant low cost exposure to 2,900 stocks across 47 countries including the US as well as emerging markets.

Moving to ETFs now helps you in 3 ways:

– You will recognize any tax loss on the mutual fund sale which could reduce your overall tax bill

– You will maintain market exposure with the ETFs

– You will avoid the capital gains distributions and taxes that will be levied on investors who do nothing

To be sure if moving out of mutual funds and into ETFs is right for you, consult with your financial and tax advisors.