Financial Abundance

In previous articles we have considered the advantages of using indexed Exchange Traded Funds (ETFs) instead of actively managed mutual funds in your portfolio.  In 2010 you may discover another risk associated with owning actively managed mutual funds in your taxable accounts.

If the stock market continues its current sideways to negative movement, by the end of 2010, many equity mutual funds will have less value in December than they did in January.  Even if your actively managed mutual funds lose value in 2010, it is likely that you will owe taxes on these funds when you file your 2010 taxes.  Here’s why:

Before the end of each calendar year, mutual fund companies are required by law to distribute of all of the income and dividends that they received.  With the large stock market gains in the second half of 2009 and early 2010, most actively managed mutual funds will have taken profits in 2010 by selling stocks that have significantly appreciated since they bought them in 2009.  These sales have produced “realized capital gains” for the mutual fund.   If the stock was held less than one year, the gain will be a short term capital gain, treated as ordinary income to the mutual fund owner.  If your mutual fund has a high turnover rate, most of the realized gains will likely be short term capital gains.

If you own actively managed mutual funds in a taxable account, near the end of 2010 the mutual fund will make a distribution that will include all of these taxable gains.  You will be required to pay taxes on these gains, even if the fund has decreased in value since you bought it.  You may also be subject to a significant amount of short term capital gains, even if you have owned the mutual fund for over a year.

Due to the large recent gains in the stock market, many actively managed mutual funds will pay large distributions to the fund owners by the end of 2010. One way to avoid paying taxes on this distribution is to sell the mutual fund before the fund’s distribution date.

Many mutual funds already have large realized capital gains for 2010.  It is wise to avoid buying these funds in a taxable account between now and year end.  If you buy these funds between now and year end, you will pay taxes for 2010 on investments that may have been sold before you even bought the mutual fund.

There are two types of mutual funds that are safer to buy between now and the end of 2010.   The first type of fund is an indexed mutual fund, which is tied to stock market indexes, such as the S&P 500.  These mutual funds typically don’t “turn over” their stocks except when changes are made to the index that they track or when they have a significant number of people selling the mutual fund .  The other type of “safe” actively managed mutual fund is a tax-advantaged mutual fund.  The managers of tax-advantaged mutual funds carefully watch their buys and their sells to minimize the funds realized capital gains.  This approach helps to minimize the annual taxable distributions from these funds.

If you are unsure of whether your actively managed mutual fund is tax-advantaged, you may call the mutual fund company before their published distribution date to determine the approximate amount of their capital gain distribution, as well as the percentages of the distribution that will be short-term and long-term capital gains.

Actively managed equity mutual funds can be a good investment if the manager has the capability of consistently beating his target index.  However, not only must you consider operating fees, 12-b1 fess and other fees associated with mutual funds, for funds held in taxable accounts, it is important to discover the tax consequences of short and long term capital gain distributions associated with the mutual funds that you own or are considering purchasing.