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What You Should Know About Year-End Distributions

Every fall investors are cautioned about inheriting a tax bill by buying mutual funds about to make large year-end capital gains distributions. Buy afterward and you can avoid an ugly surprise.

But all years are not created equal. Sometimes distributions are big; others, not so much.

How's this year shaping up? Overall it won't be too bad, but "there are a handful of doozies," Christine Benz, director for personal finance at Morningstar, recently wrote in a report.

[See: How to Max Out Your 401(k) in 2017.]

So investors are wise to check with the fund company before buying. Many have already posted distribution estimates on their website. And if big distributions give you headaches at tax time, it could make sense to rejigger your portfolio to minimize the problem in the future.

Many mutual funds pay dividends throughout the year, and lots of investors have them automatically reinvested in the fund. But the year-end payments can be especially large. They are the net profits the fund has realized from holdings sold during the year, and the government requires they be paid to investors by year-end.

If your fund is in a tax-favored account like an IRA or 401(k), it's a non-event, because you don't pay taxes until you redeem shares to make withdrawals, which may be decades later. But if the fund is in a taxable account, the distribution is subject to long- or short-term capital gains tax, even if the payment is reinvested. Using a portion of the distribution to pay the tax means reinvesting less, and that hurts your compounding over the years.

And sometimes the payments are whoppers that require the investor to come up with lots of cash to pay taxes the next April.

Morningstar cites the Columbia Acorn USA fund (ticker: LAUAX), which says it expects to distribute $4.80 to $5 a share, or about 25 percent of its current share price of around $19.50. If you had $10,000 in the fund, you'd get about $2,500, and pay $375 in taxes, assuming a 15 percent long-term capital gains rate.

At first glance big distributions look like a good thing, signifying the fund had a lot of money making holdings to sell. After all, who wouldn't want to receive $2,500 from a $10,000 investment?

But it doesn't quite work that way. When the distribution is paid, the fund's share price drops by an equal amount because its assets are reduced. So a $20-per-share fund that pays $5 a share will become a $15-a-share fund, and investors will be no richer the day after the payout than the day before. In fact, the looming tax bill will make them poorer.

That's why many advisors recommend postponing a fund purchase late in the year until after the payout if a big distribution is expected. The shares will be cheaper, you will get more of them for the same money, and you'll escape the tax bill.

"The clients I find are really hit hard by year-end distributions are those facing alternative minimum tax," says Crystal Stranger, president of Honolulu-based tax advisory 1st Tax and author of several books on taxation. "In this case every dollar that adjusted gross income increases has a corresponding effect of reducing deductions, meaning that not only are you taxed on the income but it eats away at how much your home interest and miscellaneous deductions can reduce taxable income."

[See: 7 of the Best Stocks to Buy for 2017.]

Big distributions are not necessarily a sign of great fund management. These days, many funds are packed with profitable holdings simply because the stock market has been on a roll since 2009. That has also left funds with few money-losing investments to sell to offset gains.

Finally, sales of profitable holdings are not always due to smart strategy. Morningstar notes that some funds now expecting big distributions had to sell holdings to raise cash for investors who were redeeming shares, often fleeing to buy other fund's deemed more tax efficient.

Morningstar says "investors have been opting for exchange-traded funds and index funds while dumping actively managed options." These index-style investments tend to have smaller distributions because they merely track an underlying index and don't buy and sell in a hunt for hot stocks.

Investment advisors are also becoming more diligent about steering investors away from high-fee funds and into index products, says Richard Spurgin, associate professor of finance at Clark University's Graduate School of Management in Worcester, Massachusetts.

"What changed in 2016 for the mutual fund industry was the new requirement that advisors to retirement accounts act as fiduciaries," he says. "Sponsors of 401(k) and other retirement accounts responded to this new rule by kicking expensive funds off their platforms out of concern that high-cost funds might violate this standard. While these investors don't care about capital gain distributions since they don't pay taxes on (them), their investments are pooled with taxable investors who do care."

Since those who leave the fund before the distribution do not receive it, the realized gains are concentrated among the investors who remain, making the per-share amounts even bigger, he adds.

So what can you do to avoid unwelcome distributions?

One way is to switch to index funds and ETFs. Not only are they more tax efficient, they tend to have lower management fees, and there's lots of data to show that most active managers fail to beat the indexers over time. ETFs are even more tax efficient than index funds because they don't have to sell holdings to meet redemptions. Instead, gains are reflected in the share price and generally not paid as cash, Stranger says.

If you've found a fund you really must have and it tends to make big distributions, you could buy it in an IRA or 401(k) to avoid annual tax on those payouts.

Or shop for "tax-managed" funds that make an extra effort to minimize distributions. They do things like scouring the portfolio for losers they can sell to offset gains on winners, or postponing sales of winners until 12 months have passed to get the long-term capital gains rate.

Of course, it's impossible to know which funds will have big distributions in the future. But the odds favor those with large unrealized capital gains, or lots of buying and selling signified by higher portfolio turnover. That data is available from the fund company and on Morningstar. Also look for a figure called "potential capital gains exposure."

[Read: Why Financial Advisors Are Missing the Boat.]

Another tactic -- selling out of the fund before the distribution -- doesn't work very well, according to Morningstar. That's because the big gains are already reflected in the share price, and selling shares at a profit will trigger a tax bill, too.



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