It's time to consider your funds' tax consequences
Overall, the third quarter treated investors well. But not all funds have sparkled. Some categories, such as financial services funds, have posted losses. If you're holding those funds outside a 401(k), now is a good time of year to consider harvesting your tax losses.
The general rule of thumb: Accelerate your losses and postpone taking your gains, says Bill Fleming, managing director at PWC's private company services group. So if you picked a loser, consider selling before the Dec. 31 deadline.
You can use your capital losses to offset any capital gains you may have. If your losses exceed your gains, you can subtract up to $3,000 of those excess losses from your income. If you still have losses after your deduction, you can carry them forward into the next tax year.
What if you have a loss from a fund, but you think the fund still has potential? Consider selling it anyway. If you wait 30 days after selling the fund, you can take your loss and then repurchase it. (If you buy before 30 days have passed, you'll have a "wash sale," and the Internal Revenue Service will disallow the loss.)
If, on the other hand, you're thinking of selling a fund at a profit, try to wait until after Dec. 31 to sell. That way, you won't have to pay your tax bill until 2009. (That advice might not hold water in 2010, when the law authorizing those low capital-gains tax rates is set to expire.)
Another tax tip for the fourth quarter: Don't buy a fund before it's made its annual dividends and gains distributions. Funds have to pay out any net taxable gains they have made from buying and selling stocks. (If the fund has more losses than gains, it makes no distribution.)
For example, the Growth Fund of America, the nation's largest stock fund, estimates that its capital gains distribution this year will be equal to 5 percent to 7 percent of its share price. If the fund's share price were $37.90, a shareholder with 500 shares could expect a distribution of $948 to $1,327.
Most capital gains are taxed at 15 percent. So if you owned 500 shares of the Growth Fund of America in a taxable account, you would pay $142 to $199 in additional 2007 taxes.
Your fund may make a dividend distribution, too. Most qualified dividends are taxed at 15 percent. (Qualified dividends are those from stocks of most U.S. corporations. Interest from bonds and money market securities don't qualify for the lower rate; they're taxed at your income tax rate.) Your fund will tell you what percentage of your dividend distribution is available for the 15 percent rate.
Don't think that you're getting something extra from your fund when you get your year-end distributions. Your fund's share price will drop by the amount of the distribution. You'll have the same amount of money in your account; you'll just owe taxes on part of it.
What if you buy shortly before the distribution? You'll get the same distribution as everyone else, meaning you'll be paying taxes on gains you probably didn't get to enjoy.
"Don't buy into a distribution," Fleming says. If you expect a big distribution, you may want to increase your withholding for the rest of the year to avoid underpaying your taxes and potentially facing a penalty, he says.
Many funds are starting to post estimates of their capital gains now, as well as estimates of when they'll make their payouts. If you're not sure, ask the fund company or your broker.
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