Hidden Capital Gains

You have no control over the distribution of hidden capital gains from mutual funds, which can upset careful tax planning. Because investment companies do not pay taxes, all income and capital gains in the fund are passed through to shareholders. If a fund has bought and sold investments at a gain, these gains are passed on to shareholders when the fund distributes its gains. Shareholders are liable for the taxes on these capital gains even if the share price of the fund has dipped below the purchase price.

The following example illustrates this concept: Suppose that you purchase 1,000 shares in a mutual fund at $10 per share. The next day the mutual fund distributes capital gains of $2 per share. The share price declines to $8 per share ($10 – $2 capital gain per share). You now have 1,250 shares at an NAV of $8 per share ($2,000 capital gain / $8 NAV = 250 shares). If you continue to hold the shares until year-end, you are liable for the taxes on the $2,000 distribution of capital gains. If you decide to sell all the shares in the fund when the distribution is made at the NAV of $8 per share, you receive $10,000 and experience a loss of $2,000 ($10,000 in proceeds minus the adjusted cost basis of shares is $12,000). This loss is offset by the capital gains distribution, and no tax consequences occur.

In another scenario, suppose that you hold the shares and the share price declines below $8 per share. You are still faced with $2,000 of capital gains, even though the principal is now less than the $10,000 invested. This happened at the end of 2001 when the stock market declined during the latter half of the year. Investors were saddled with capital gains distributions while their principal diminished because of the decline in their funds’ NAVs.

New investors should avoid buying into a mutual fund toward the end of the year because they can increase their tax burden from hidden capital gains. Before buying into a fund, investors should investigate whether the fund has accumulated any capital gains distributions that have not been distributed to shareholders. These gains are passed on to shareholders at the end of the year through a capital gains distribution, even if the shareholders did not own the fund when the gains were incurred.

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