Beware Year-End Fund Distributions

Is November too late to buy a new fund? Would year-end capital-gains distributions make it unwise to invest right now?

QUESTION: Is November too late to buy a new fund? I've been told that since funds pay out dividends and capital gains in December, it's unwise to invest late in the year.

ANSWER: You're certainly prudent to ask the question. Because of some tricky tax issues, November can indeed be a poor time to purchase mutual fund shares. We'll provide a tutorial on the potential pitfalls -- and then tell you why you probably don't need to worry about this issue too much, at least not this November.

At issue here is the unfortunate situation known as "buying the distribution." This happens when new investors get stuck paying a tax bill on investment gains in the fund that they weren't around to enjoy.

Each year, mutual funds are required to distribute 98% of their net realized gains to shareholders -- or face nasty tax penalties. These distributions are paid out to all shareholders as of the "record date" (which usually falls during November or December, but varies by fund). So if you invest in a fund, say, the day before the record date, then, like it or not, you'll get a slice of that annual tax burden. (One notable exception: If you purchase shares in a tax-advantaged account, like a 401(k) or IRA, you won't owe taxes this year on the distribution.)

Say that on Oct. 31, a fund with a net asset value (NAV) of $10 announces that it will make a 2004 capital gains distribution that consists of a short-term gain of $1 per share and a long-term gain of $2 per share. On the date the distribution is deducted from the fund (known as the "ex-dividend date"), the fund's NAV will drop by $3, which means it falls to $7. Usually, folks choose to have their distributions reinvested, which means the distribution is automatically used to purchase more shares at the lower price, so each shareholder's balance remains the same. (In other words, they now own more shares, but at a lower price.)

But taxes are owed on that $3 distribution. Short-term gains are taxed as ordinary income, while long-term gains are generally taxed at 15% (as are most dividends, which are often included in total year-end distributions). So if you bought 100 shares just before the record date, $300 of your $1,000 investment would immediately be taxable. Just how big a tab that would be depends in part on your tax bracket. Ordinary income rates can run as high as 35%. (For more on mutual funds and taxes, click here.)

The good news: This unfortunate situation can easily be avoided by purchasing the shares after the record date. Already, many fund families have posted distribution estimates (based on Sept. 30 data) on their Web sites. For most funds, final figures will be based on Oct. 31 data. Alternatively, you can make a quick call to the fund's customer service line to confirm that you're in the clear.

And while we would never discourage you from doing your due diligence, we do predict that relatively few funds will issue sizable year-end distributions this year. In fact, most won't issue any at all. You can thank the 2000-02 bear market for that. The fact is, many funds are still carrying forward losses reaped during that time period, which they can use to offset realized gains this year.

That said, there are still some fund types you should keep a careful eye on, warns Tom Roseen, senior research analyst at fund-tracker Lipper. These include young funds (that weren't around during the bear market) as well as small-cap funds, value funds and certain sector funds -- like natural resources funds -- that have had good runs recently.

Now, a more complicated question is, if you're interested in a fund that's likely to issue a distribution, should you wait to make the purchase until after that distribution has been made? Not necessarily, says Sheldon Jacobs, editor of the No Load Fund Investor newsletter. The pain of a small distribution could be made up easily in the fund's short-term performance. "If you really think the market is going to go up strongly in the next seven weeks, you should buy anyway," he says.

Here, you need to consider just how bullish you are over the short term on the potential performance of the fund -- and weigh that against the size of the distribution. Of those funds that will issue a distribution, most won't be more than roughly 2% of assets. Compare that to what we saw in 2000, when the average (based on no-load funds that issued a distribution) was 9.6% of assets and most funds had negative returns that year. Tax brackets were also higher then, notes Jacobs, which made distributions even more painful.

That said, if the market is in the midst of a nice bull run, you can bet that distributions will become more common in the future. So don't ignore this issue altogether. The fact is, when investing in a taxable account, you should always pay attention to tax efficiency. Taxes are "one of the biggest long-term drags on performance that we have," says Roseen.

Year-End Distribution Estimates From the 10 Biggest Fund Families*

- Vanguard -- Year-end distribution information will not be posted on the Vanguard Web site until early December, but investors can get estimates now (based on Sept. 30 data) by calling 800-662-7444.
- Fidelity
- American Funds
- Franklin Funds
- Pimco
- T. Rowe Price
- Putnam -- Putnam sells its funds exclusively through intermediaries, so it has posted its estimates on its advisor site.
- Oppenheimer Funds
- Barclays Global Investors -- Estimates are not available, but a schedule is available on the Web site.
- MFS Investment Management -- Estimates are not yet available.

* According to Financial Research Corp.; September 2004 data.