By Chuck Jaffe
BOSTON (MarketWatch) — Last week, as I gathered all of the information my tax preparer needs to work on my return for 2010, I called the Wasatch funds to make sure I wasn’t missing anything.
I have held one of the Wasatch funds for many years, and it has always thrown off a sizeable capital gains distribution; I didn’t have any tax records and was worried I had somehow missed paperwork.
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I don’t lose or miss paperwork. I was pretty sure that the fund had not paid out any capital gains, offsetting trading profits with loss-carryforwards it had from 2008 and 2009. Indeed, that proved to be the case.
“But don’t worry,” the phone representative told me, “because we’ll probably have gains for you at the end of this year.”
Worry? Are you kidding me? To quote Arthur Godfrey, one of my father’s favorite entertainers, “I’m proud to pay taxes in the United States; the only thing is I could be just as proud for half the money.”
The tax man cometh
Millions of fund investors got a tax holiday for 2010, despite the fact that the market was strongly on the rise. But many funds did well enough in 2010 to chew up the bulk of their previously realized losses, which means that taxes are likely to become a story to fund investors, no matter which way the market heads this year.
Mutual funds are “pass-through” securities” — tax obligations pass through the fund and on to shareholders, who are on the hook for their share of taxes due. Funds must distribute virtually all capital gains realized from trading securities; unless you put a fund that trades actively into a tax-deferred retirement account, you could get slugged with a heavy tax bill each year.
There are worse things than receiving taxable distributions — like losing money, for example — but in 2007 and 2008 many funds sold securities on which they still had a profit, trying to protect long-term wins. Thus, while the funds mere going through the market meltdown, they were also paying out big distributions, the proverbial “double whammy” of being hit with a tax bill for gains at the same time a fund is showing losses for the year.
Funds had more long-term winners than they had short-term losers when the market crisis began, so the tax bills were big. Then, having sold off the winners, funds racked up losses trading securities in 2008 — losses so big that in many cases they offset gains earned as the market picked up in 2009 and 2010.
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Now, with most of those losses having been used up, there’s a good chance that many funds will say goodbye to the tax holiday in 2011, generating distributions again. Shareholders may not mind an up year for a fund that comes with a distribution — but the double whammy will return the next time there’s a significant market freefall.
Read the fine print
“Some people might find that their tax holiday continues through this year, but it’s clearly coming to an end, especially in the kinds of funds that have been the hottest,” said Tom Roseen, senior research analyst at Lipper Inc., who runs the firm’s study of taxable distributions.
Roseen suggested that investors check to see if their tax holiday will continue by looking at a fund’s annual report, in the notes section behind the financial statement, to see how much of a tax-loss carryforward is left and how many years the fund has to use those losses.
Investors should also compare their year-end statements for the last few years — or examine several years of tax returns — to see the real impact of tax efficiency. Compare the distributions generated several years ago against the zeroes most likely put up in 2009 and 2010; even though long-term capital gains rates are favorable now (15% for the highest tax bracket through 2012), those taxes represent a significant drag on fund performance.
“People should not miss the importance of what they are seeing now,” Roseen said. “If you are thinking ‘Wow, this is easy and nice with no distributions,’ then you might want to think about how much you hate it when you have those distributions and whether that means you want to look for something tax-efficient for your portfolio.”
Chuck Jaffe is a senior MarketWatch columnist. His work appears in many U.S. newspapers.