Mutual Fund Distributions Headache - Get Ready

[JohnH]

I read an article this morning which reminded me of a problem we've all dealt with in the past, but it may hit especially hard this upcoming tax season. During the financial meltdown, many panicked investors bailed out, forcing mutual funds managers to sell shares to raise cash to meet cash calls. This means many of these funds will likely be reporting larger than usual Capital Gains Distributions, including large short-term gains and non-qualified dividends taxable at ordinary income rates.

It's not very hard to explain CGD's in good times. When the client asks why they're being taxed on money they didn't receive, it's easy enough to show them that they now own more shares without paying out any more money, plus the value of their fund went up. But it's much harder to explain to someone that they are paying more tax than usual on their CGD's this year and at the same time their mutual fund is worth 20, 30, 40% less than it was last year. This could be a long tax season.

[Roberts]

I've read that the funds making distributions are funds that invested primarily in foreign markets. Those funds had large ramp ups in value and even with a 40% loss had stocks with significant gains. Domestic funds shouldn't be a major factor. The US stock markets are below where they were 8 years ago so unless the fund has an extremely low turnover ratio, they shouldn't be seeing major distributions.

[ChEAr$]

True

I've read that the funds making distributions are funds that invested primarily in foreign markets. Those funds had large ramp ups in value and even with a 40% loss had stocks with significant gains. Domestic funds shouldn't be a major factor. The US stock markets are below where they were 8 years ago so unless the fund has an extremely low turnover ratio, they shouldn't be seeing major distributions.

\

but in perusing the preliminary year end fund distirbutions statement from T Rowe Price,
it looks like some of my primarily US type funds also have nice forecasts. Thank God
all mine are in retirement accounts.

[erchess]

Temptation

I have always wanted to have a rule for clients that want to own mutual funds outside of retirement accounts. The rule is that you buy at one time all of a given fund you are ever going to buy and when you sell you sell all you own - or you get someone else to do your taxes. I haven't actually done that and I won't but it is tempting.

[joanmcq]

Or you buy them in a fund that gives you the cost basis and a breakdown of short and long. T.Rowe does this, and is one of the reasons I like them. I am, however, tempted to identify and sell off some shares I hold in a taxable account that I've had for 15 years if I can get my income low enough for the zero percent gains rate. and then buy back in 30 days!

[JohnH]

That would be helpful, but on the other hand the spreadsheets for multi-year ownership with reinvested dividends are so much fun to do (and to charge for).

The main point of my post really isn't the sellers - usually they will know they have gains or losses to report. I'm talking about those who stayed in place with their mutual funds, have seen them drop considerably in value, but find when they open their year-end statements that they have a 1099-B showing significant Capital Gain Distributions, Short-Term Gains, etc and learn that they are going to have to pay tax on earnings in an asset that's declining in value. Those folks are going to have a hard time understanding why this is so, and it won't help much to explain to them that they get to add those CGD's to their basis when they sell at some time in the future. \

I think the last time this happened in a big way was back in 2001, and I found it to be a real headache.

[erchess]

I realize that

CGDs for which you are taxed without getting the money are added to basis but can anyone explain why it is fundamentally fair to tax someone on money they neither received nor had the choice of receiving? Can anyone explain what the law is on this subject? (Notice that I asked two questions that do not relate in any way.)

[taxea]

Mutual Fund Distributions Headache - Get Ready

First of all I tell them they should have called me before they made any investment changes.
Second if the year end statement from the investment company does not contain all the info I need, #of stock, purchase cost, date purchased, basis at time of sale, sale amt; I require them to get it from the investment company.
The rub is when they have moved their investments to a different company. If they come back to me saying the company can't give them the original information then I ask them to have the company provide them with approximate figures.
When I get a new client with investments I recommend they put their statements into a 3 ring binder, separated by company and to file each new statement on top of the prior statement.
I truly don't understand why these companies don't stress the importance of keeping every statement as long as the client holds the investment.
I do have clients that bring me their binders each year they have sold investments and if I have to do the FIFO calculations...they get charged for my time.taxea

[JohnH]

CGDs for which you are taxed without getting the money are added to basis but can anyone explain why it is fundamentally fair to tax someone on money they neither received nor had the choice of receiving? Can anyone explain what the law is on this subject? (Notice that I asked two questions that do not relate in any way.)

It's "fair" because it's disclosed as a part of the basic rules of the game. And when it comes to investments, you are never taxed on the cash you get in your hand, you are taxed on the increase in value when a transaction takes place. Being taxed on CGD's is essentially no different than selling one stock and buying another, but in the case of a mutual fund you are leaving it to the fund manager to make those timing decisions for you. (Plus you are leaving it to your fellow investors to force the manager to sell when he doesn't want to do so in order to meet cash requirements when they bail out in a panic situation) There are many situations in which we pay tax on money we didn't receive, such as the income tax we pay on the Social Security and Medicare tax withheld from our paychecks.

Those are the rules you live by when you buy a mutual fund. The taxpayer does have a choice because they can avoid ever being taxed on CGD's simply by not buying any mutual funds. There's also the option to have distributions paid out rather than reinvested, but that somewhat defeats the underlying purpose of investing unless one needs the distributions to suppelment current income.

The other choice would be to change the rules such that the mutual fund would pay tax on the gains, but the only consequence would be that the value per share would be lower by a factor of the taxes paid plus the additional administrative & compliance costs of processing the additional atx paperwork. The net result would probably be roughly the same either way.

[FEDUKE404]

There IS income for CGD

CGDs for which you are taxed without getting the money are added to basis but can anyone explain why it is fundamentally fair to tax someone on money they neither received nor had the choice of receiving? Can anyone explain what the law is on this subject? (Notice that I asked two questions that do not relate in any way.)

Correct me if I'm wrong, but I thought when a fund has capital gains distributions that one of two things then occurs: 1) The taxpayer actually receives that money or 2) The taxpayer receives additional (reinvested) shares in the fund.

While the value of the underlying fund shares is most likely crashing in 2008, there is something of taxable value received, yes?!?

FE

[Gretel]

This is my understanding too. Whatever after the CGD has nothing to do with the distribution itself.

I guess it's like saying our taxable income shouldn't be taxed at the value received because at year end inflation has eaten up 20% (fortunately inflation isn't that bad, just to make a point) of it's value.