Don't buy a tax liability
This time of year can be a danger-ous one for mutual fund investors.
It’s distribution time – when mutual funds pay out some of their largest taxable distributions of income and capital gains during the year.
If you’re buying mutual funds in a taxable account, these distributions are taxable to you, whether you reinvest them in new shares or let them go to cash. Investing a large amount (say $1,000 or more) in a mutual fund just before a big distribution is a bad move. You pay tax on the distribution but get no real benefit from it.
Before investing toward the end of the year, smart investors check with the fund company to determine whether they’re buying a tax liability. If the distribution will be more than 5%, it’s probably better to wait until on or after the fund’s “ex-date” to buy your shares.
This year is expected to be worse in this respect than the past few years. After the dot-com bubble burst in 2000-2001 many funds had years worth of capital losses to carry forward, which reduced or eliminated the capital gains distributions that they were forced to pass on to investors. Now, many funds have used up their losses and can no longer offset their gains.
Some of the most tax-efficient funds are ETFs and index mutual funds, since, due to their nature, their portfolios have less turnover. However, even some actively managed mutual funds are efficient, because they strive always to offset gains with losses.
If you are considering buying a mutual fund in a taxable account, it’s a good idea first to check the fund’s tax efficiency.
