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Across My Desk: Capital Gains Payouts

If you haven't done your taxes yet, keep in mind that capital gains payouts on mutual funds rose for the fourth straight year in 2007.

Russell Kinnel, Morningstar's director of mutual fund research and editor of Morningstar FundInvestor, addressed this tax-ouch in February. Below are excerpts from his piece dated Feb. 11, 2008:

  • In 2007, the average U.S. equity fund paid out 6.89% of year-end net asset value. That compares with 4.17% of assets in 2006, 3.32% in 2005, and 1.67% in 2004.

  • For international equity, the average payout grew to 7.49% compared with 4.98% in 2006.

  • For balanced funds the payout jumped to 3.0% from 1.95%.

  • For taxable-bond funds, the payout rose to 0.20% from 0.12%. (The main tax bill for holders of taxable bonds and bond funds is on the income, which is taxed at a higher rate than long-term capital gains.)

    That means: 75% of U.S. equity, 83% of foreign equity, and 83% of balanced funds had capital gains payouts last year.

  • "The main reason for the surge is that capital gains payouts reflect gains accumulated over previous years. In 2003 and 2004, many funds had bear market losses to offset their more recent gains. By now those charge-offs are largely gone and most funds have to pay out capital gains when they turn over their now-profitable portfolio. If the downturn we saw in January(2008) gains steam, the trend would likely reverse," he said.

    Kennel reminds investors that there's a big difference between appreciation and capital gains distributions. "A fund could appreciate a lot and not make a payout. That would allow you to continue compounding your returns and at the same time postpone your tax bill in the future when money is worth less. (You'd rather have $200 today than a promise for $200 in 10 years.) In addition, a fund could give you a big tax bill even though you haven't made a dime, because capital gains are based on gains that the fund realized and distributed to all shareholders equally regardless of their cost basis."

    Here are some of Kinnel's ideas on how to limit capital gains payouts this year:

    1. Max out on tax-sheltered accounts by investing as much as the law will allow before you put money in your taxable accounts.

    2. Consider tax-managed funds for your taxable accounts. Tax-managed funds, such as those offered by Vanguard, do a great job of avoiding making distributions because they realize losses on some holdings when they have to realize gains on others.

    3. Consider exchange-traded funds. Just make sure you've chosen ETFs that are diversified, have low costs, and low turnovers.

    4. Don't buy funds that have had huge returns over the past three years. Buy a fund with huge gains and you're going to get a huge tax bill regardless of whether you make any money yourself. Find a specific funds' potential capital gains exposure on Morningstar.com by clicking on its Tax Analysis tab on the left-hand side of the page. This will clue you in to whether a fund has built up a lot of gains.

    Thank you, Rus.

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