CGV Basics – Don’t buy a tax headache!

Dan just read “10 Mutual Funds You Must Buy Now!” in his favorite financial magazine. On Thursday, he invested $10,000 from his personal account into one of the funds from the article. On Friday, that fund made a capital gains distribution. In fact, the fund distributed 5% of its net asset value as a short-term capital gain and an additional 10% as a long-term capital gain. Due to this purchase, he’s added $1,500 in taxable income ($500 in ordinary income and $1,000 in long-term capital gain) to this year’s return. In his tax bracket, this cost him $410 in taxes even though he’s only owned the fund for one day. Tax headache!

What could Dan have done differently?

For starters, Dan probably should think twice before he follows the advice from these types of articles (remember Steve Forbes’ quote: “You make more money selling advice than following it.”) but I digress. More importantly, before making mutual fund investments at year-end, Dan should determine if and when the fund is going to make a distribution. Waiting until after the fund’s distribution “ex-date” would have saved him some money.

What options does Dan have if he really wants to purchase this fund? Here are several:

  • Bite the bullet and pay the taxes – These increase Dan’s cost basis and will result in less taxable gains in the future; this will eventually offset some of today’s pain.
  • Wait until the fund makes its distribution – This could result in lost gains if the holding does well while you’re waiting.
  • Make the purchase in a tax-deferred account – Investments made within IRAs, Roth IRAs, 401(k)s, etc. don’t have to worry about these issues.
  • Buy a similar holding – Index based exchange-traded funds (ETFs) might be a better option. ETFs can be incredibly tax-efficient; very few of them have ever made a capital gain distribution.



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