Don't Buy a Tax Bill with a Mutual Fund

Eurozone problems and federal budget deficit woes have spooked many investors. While some have fled the stock market for the shelter of more conservative investments, others view the recent market volatility as a buying opportunity.

SEE ALSO: 12 Year-End Tax Moves to Make Now

If you are one of those silver-lining investors, consult your calendar before you start pouring money into the stock market. Buying mutual funds between now and the end of the year could trigger an unnecessary tax bill.

Sometime in December, many funds pay out dividends and capital gains that have built up during the year, and the payout goes to investors who own shares on what's known as the ex-dividend date. It might sound like a savvy move to buy just before that day so you get a whole year's worth of income. That's not how it works, though.

Yes, you'd get the payout, but at the time of the payout, the share price falls by exactly the same amount. If you get $2 a share in dividends, for example, the share price drops by two bucks. In effect, the fund is simply refunding part of your purchase price.

But the IRS doesn't see it that way. You have to report the payouts as income on your 2011 return -- and pay taxes on them -- even if the money is automatically reinvested in extra shares. (The tax threat does not apply to mutual funds held in 401(k) plans or other tax-deferred retirement accounts.)

Before you buy shares for a nonretirement account in December, call the fund company or check its Web site to find out exactly when the dividend will be paid so you aren't buying a tax distribution.

Buy after that date and you'll not only get a lower price, but you'll also avoid a tax bill. If you buy before and get stuck with the tax bill, there is one consolation: You'll have a higher tax basis . . . and a lower tax bill when you ultimately sell the shares.