The guidance against buying mutual fund shares in December prevents you from getting hit with a big tax bill on phantom profits -- at least phantom to you. Mutual fund companies must pass along to investors net gains once a year, and the companies all make those distributions in December. So if you buy fund shares at the wrong time, you can end up paying taxes on a lot more profits than you actually earned.
Capital Gains Distributions
If a mutual fund ends the year with net profits on the investments sold during the year, those gains must be paid out to fund investors as an annual capital gains distribution. Funds typically make the capital gains payouts during the last couple of weeks of the year. Since gains are only paid out once a year, any capital gains distribution represents 12 months worth of profits on the fund's portfolio. If a fund had a good year, the amount of the distribution can be significant.
Share Price Effects
When a mutual fund pays a year-end distribution, the share price drops on the distribution date by the amount of the payout. Let's say a fund pays a $1-per-share capital gains distribution and the share price is $10. The day after the distribution, the share price will be $9 and investors in the fund get the $1 per share payment, which can be received as cash or reinvested into more shares. The one-buck payout represents profits the fund generated for the full year.
If you own fund shares that pay a capital gains distribution, you will receive an IRS Form 1099 listing the amount you were paid. You must claim that money on your tax return and pay the appropriate taxes. If you buy shares just before a distribution, you will pay taxes on the full amount, even though you do not have that much profit in our investment.
Consider the bad timing of buying 1,000 shares of the $10 fund the day before the distribution. The next day, your value is $9,000 for the shares and $1,000 for the distribution. Then you have to claim the $1,000 as taxable income. You made nothing in profits and will get hit with several hundred dollars in taxes.
Look Before You Leap
The payment of a large capital gains distribution by a mutual fund should not be a surprise. Funds publish the date and expected amount of capital gains distributions well in advance of the actual payment dates. If you are thinking about buying into a mutual fund in late November or December, look on the fund's website for the upcoming distribution information. If the fund you want will make a big capital gains distribution, buy the shares the day after and avoid paying real taxes on phantom gains.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.