Those Not-So-Nasty Capital Gains

published 30 November 2006

This is the time of year when some advisers and financial journalists bemoan fund distributions. The script goes like this: Funds must pay out essentially all of the past year's net realized gains.

The payments don't change the value of your funds, but you owe income taxes on the amount disbursed. To make matters worse, 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). For example, T. Rowe Price New Asia expects to make a distribution amounting to 13% of net asset value per share; Janus Global Opportunities also expects to pay out 13% of NAV.The advice that flows from all this is predictable: Don't buy funds before they make big payouts. If it were only that simple. Operating on the principle that the tax tail shouldn't wag the investment dog, we propose a different approach: Be aware of late payouts, but if you like the fund and are bullish on the market, don't sweat them.

Paying taxes on distributions isn't permanently lost money. Instead, as New York financial planner Lewis Altfest puts it, "You'll pay on April 15, but you'll owe less when you sell." That's because payouts boost your tax basis if you reinvest your distributions. For example, if you have $10,000 in a fund and it pays out a $1,000 capital-gains distribution, your new tax basis is $11,000 if you reinvest. If over, say, the next year, your fund grows in value to $11,000 and you then sell, the extra $1,000 in appreciation won't be taxed. If you take the payout as cash, you'll have fewer shares to sell later, thus reducing your tax bill at that time. And if your fund is in a tax-sheltered account, none of this matters one whit.