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December, 2008 Tax Tip

Avoid the Tax Trap for Fund Investors


Even if your mutual fund has lost 40% or more in the stock market decline, be aware that it may deliver a capital gains tax hit to you this month.


Because of the big market plunge many investors have cashed out of their funds.  In turn, this has caused many funds to sell appreciated securities in their portfolios in order to redeem these shares.  The appreciation most likely occurred during the five-year bull market.


When a mutual fund sells appreciated securities it realizes taxable capital gains that, by law, are passed through to their investors when the fund makes taxable distributions.  It is quite common for this to occur in December.  Some of the capital gains may be short-term gains and nonqualified dividends which are taxed at ordinary income tax rates up to 35%.


It should be noted that some mutual funds may not be in this tax-trap situation.  If your fund sold investments that declined in value, the fund may have capital losses to offset its capital gains.


However, if you are caught in the trap here are a few planning thoughts:


Find out the expected distribution date and amount of the funds you own or in which you are considering investing.  Often this information is available on the funds’ websites.


Very Important:  Find out the fund’s ex-dividend date and purchase shares after that date!  Otherwise, you will be receiving distributions upon which you might be paying capital gains tax or, worse, income taxed at ordinary rates.  The value of the shares will drop by the total amount of the distributions causing you to pay a current tax without receiving additional value.  This is known as “phantom income”. 


If you will be receiving capital gains from one of your funds, you should consider selling shares in another fund or other stocks you own that have lost value to offset the gains.  Capital losses offset capital gains and up to $3,000 of other income.  Unused losses are carried over to succeeding years to offset gains and up to $3,000 per year of other income in those years.


It is highly recommended that you discuss these strategies, and your securities situation in general, with your tax practitioner or financial advisor.




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