Tax Tips
Don't Buy a Tax Bill
If you're thinking of purchasing mutual funds between now and the end of the year, think twice -- you might end up owing Uncle Sam.
By Mary Beth Franklin, Senior Editor, Kiplinger's Personal Finance
December 5, 2006
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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 is known as the ex dividend date. Some stock funds that have performed well in the past few years will make larger-than-usual distributions this year. (Fund firms often post payout estimates on their Web sites.)
Now, it might sound like a savvy move to buy just before that day, so you get a whole year's worth of income. But it doesn't work that way. 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, the share price drops by two bucks. In effect, the fund is simply refunding part of your purchase price.
But that's not the way the IRS sees it. You have to report those payouts as income on your 2006 return -- and pay taxes on them -- even if the money is automatically reinvested in extra shares so you never really see it. Paying taxes on distributions isn't permanently lost money, however. It increases your basis and reduces the amount of tax you'll pay when you eventually sell. Still, it's better to pay taxes later rather than sooner.
So, before you buy shares in December, call the fund or check its Web site to find out exactly when the dividend will be paid. Buy after that date, and you'll not only get a lower price, but also you'll avoid a tax bill.