Plan Early for your Taxes

09/10/00 07:34:33 PM PST

by Jayanthi Gopalakrishnan

OK so April 15th is months away. Why worry about taxes now? Unfortunately if you are a mutual fund holder or have sold securities during the course of the year, you may have to end up paying a hefty check to Uncle Sam. To better prepare yourself for the unexpected here are some factors you should keep in mind.

MUTUAL FUND DISTRIBUTIONS
If you own mutual funds you will have to pay taxes on your capital gains. Mutual fund managers buy and sell stocks that make up the fund and any gain realized from their sale is taxable. This gain is distributed among the shareholders of the fund. It is determined by the number of units owned by the investor on distribution day multiplied by the distribution per unit.
Unfortunately this year may bring some surprises. Although most mutual funds may show lackluster returns compared to previous years it is possible that you may end up paying higher capital gains taxes. Most mutual funds pay out capital gains distributions towards the end of the year but there are some that pay them out earlier. Having an idea of how much these funds pay out in distributions gives you a better idea of what to expect from your funds. One example is Warburg Pincus Japan Small Co fund (WPJPX) that had a 55.06%-of-assets distribution on 8/14/00 even though this year's returns were sharply lower than the 329% of the previous year. During the early part of 2000, the value of the technology sector rose by leaps and bounds. It is likely that some fund managers may have taken advantage of these gains by selling out prior to the sharp fall in April. These profits are passed onto the shareholders and if you happen to be the holder of such a fund, it is possible that you may have to pay larger than expected capital gains taxes.

...Prepare Yourself

Some fund companies warn their shareholders about expected payouts. It is worth your while to read all correspondence you receive from your mutual fund company.

Check quotes/charts of your mutual funds on a regular basis. If you notice a drastic drop in prices in any one given day then it may be due to distributions being paid out. The amount of this decrease should give you an idea of how much to expect in capital gains.

Set aside enough capital to cover capital gains taxes.

FIGURE 1: A drastic drop in mutual fund prices may be associated with distribution payouts.

DEFER PURCHASING MUTUAL FUNDS UNTIL AFTER DISTRIBUTIONS
If you are planning on investing in a mutual fund it is recommended that you wait until after distributions. Most mutual funds make distributions at the end of the year so if you buy before a distribution, you will end up paying taxes on the fraction of your investment that will be returned to you. This may end up being a loss for you since you would have only been a shareholder for a short period of time.
To clarify, suppose you buy 500 shares of Fund ABC at $5 per share. Shortly thereafter, the fund pays out distributions of $1.00 per share. So, $1.00 of your $5.00 Net Asset Value Per Share (NAV) is being distributed to you. You can receive this $500 (500 shares X $1.00) in cash or reinvest it into your fund and receive additional shares. Either way you have to pay taxes on this distribution.

...Prepare Yourself

Call the mutual fund company and find out their ex-dividend or distribution date.

Invest in the fund subsequent to this date.

INDIVIDUAL STOCKS
If your portfolio consists of individual stocks you should be aware of any capital gains you have accumulated during the course of the year. There is a difference between long-term and short-term capital gains. Long-term capital gains are those realized from securities held longer than one year and taxed at 20%. Short-term capital gains are gains realized from securities held for less than one year and are taxed as ordinary income.

...Prepare Yourself

Sell securities that have gone down in price since you bought them. Capital losses can be used to offset capital gains. You are entitled to reduce your gains by a maximum of $3,000 per year. Losses greater than this have to be carried forward to the following year.

If you think the stock will recover over time, there is no harm in selling now, accounting for the loss to get the tax benefit, and repurchasing the stock the following year. Keep in mind the wash sale rule; wait 31 days to repurchase the stock otherwise you can't count your losses.

There are more complex strategies such as shifting between funds within the same fund family that can be incorporated to reduce your taxes. These will vary among individuals so it is always a good idea to consult your tax advisor or financial planner before the end of the year.

FIGURE 2: Don't let large capital gains catch you by surprise.

Jayanthi Gopalakrishnan

Staff Writer

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