If you invest in mutual funds, proceed cautiously at year-end. At this time of year, funds may distribute any net capital gains for 2010 to their shareholders. These distributions are taxable to investors (unless the fund is held in a tax-favored retirement account), and the share price typically drops to reflect the distribution.

Example 1: Caitlin Carter invests $10,000 in Mutual Fund ABC in early December 2010. She acquires 500 shares at $20 apiece. One week later, ABC makes a $2-pershare capital gain distribution, and the share price drops to $18. Caitlin owes tax on a $1,000 capital gain distribution ($2 per share x 500 shares)-even though the distribution is essentially a return of her own money. Therefore, if you are going to invest in a mutual fund between now and December 31,2010, you may be better off waiting until after any distribution. You might be able to avoid this tax trap and buy at the post distribution reduced trading price. Check the fund’s website for information about capital gain distributions; if the fund won’t distribute capital gains because of bear market losses, you can buy at a time of your choosing.

If you are thinking of selling mutual fund shares, on the other hand, you may decide to advance your plans if you learn that your fund will make a capital gain distribution.

Example 2: Steve Davis invested $10,000 in Mutual Fund XYZ many years ago. He now owns 700 shares of the fund, trading at $25, for a total of $17,500. Steve wishes to take his gains in 2010 while the maximum tax rate on long-term gains is 15%. On the XYZ website, Steve sees that a $3 per share distribution is planned for December 15,2010. The fund estimates that $2.50 per share of that distribution will be in the form of short-term capital gains from last winter’s rally. Thus, if Steve holds onto his shares, he will receive a distribution of $2,100 ($3 x 700 shares), most of which will be taxed in his 28% ordinary income tax bracket as short-term capital gains.

Instead, Steve sells before XYZ’s distribution. With a $10,000 cost basis and a $17,500 selling price, Steve will have a $7,500 long-term gain, all of which will be taxed at only 15%.

2010 Q4 | Year-End Tax Planning for Mutual Funds
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