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There are only a couple of weeks left in the year, and in the few minutes we're not all stringing up holiday lights or crossing gifts off our shopping lists, you might want to take a few minutes to think about your year-end investment portfolio. More specifically, if you have one or more taxable accounts, you need to consider the tax ramifications of the various movements of your securities throughout the year.
The closing weeks of the year are the time to examine your portfolio and think about tax-loss harvesting, or selling some of your securities at a loss in order to offset capital gains elsewhere in your portfolio. But there's another aspect to year-end investing that mutual fund investors need to keep in mind.
Taking a handout
By law, mutual funds are required to pay out at least 90% of their net capital gains and income to shareholders each year. This typically happens via shareholder distributions, which by and large occur toward the end of the calendar year. Here, the fund makes a cash payment to its fundholders, directly reducing the net asset value, or NAV, of the fund by a similar amount. So if your fund was trading at an NAV of $25 immediately before the annual distribution and it makes a distribution of $2 in cash, you will now see reflected in your brokerage statement the fund with an NAV of $23 and $2 in cash.
A lot of investors tend to forget about this year-end phenomenon and freak out when they see that their fund has suddenly dropped in value. So if you see this kind of sudden decline in your fund's value, and the market hasn't been on a losing streak, take a minute to double-check to see if a distribution has been made.
Now if you're looking to purchase a new mutual fund or two in a taxable account, there's one general rule of thumb to follow: Don't buy new funds at the end of the year. Or at least hold off until you look at the fund's distribution schedule. This is important because as a fundholder, you are responsible for paying taxes on any distributions you receive, even if you bought the fund a few days before the distribution was made. In other words, you could end up owing taxes on capital gains that you didn't even benefit from by owning the fund during the year!
If you weren't planning on footing this extra tax bill, year-end distributions can be a nasty surprise. The vast majority of funds tend to make their annual distributions in November and December, so if you're thinking of buying late in the year, be sure to find out when the distribution is scheduled and make your purchase after that date. With the market being pretty much flat to slightly negative this year, many funds may not be making any distributions at all, but you should still verify this before buying.
Pay it forward
Let's take a look at one example. If you own individual shares of low-P/E dividend-producers like IBM (NYSE: IBM ) or Wal-Mart (NYSE: WMT ) , you're used to getting a quarterly dividend. According to historical data, IBM paid out a dividend of $0.65 per share this past February, and a $0.75-per-share dividend in May, August, and November. Likewise, Wal-Mart has paid out a $0.37-per-share dividend in the last three quarters, and a $0.30 dividend in December 2010.
But what if you own these stocks in a fund, like Sequoia (SEQUX), where both names land in the portfolio? According to Sequoia, the fund made a long-term capital gains distribution earlier this month of $0.82 per fund share, so that's what investors need to watch for. With that distribution out of the way, taxable investors should feel free to make new purchases.
Fund distributions can be easily managed with just a little bit of planning and double-checking. Your fund company's website should have information on historical distributions and upcoming estimated year-end distributions. And while most funds make their distributions at year-end, not all do, so make sure you know when your fund makes its payouts.
Now if you're really concerned about fund distributions, one way to cut down on your potential exposure is to own relatively more tax-efficient investment vehicles like exchange-traded funds. Since ETFs don't trade anywhere near as much as most actively managed funds, there is less opportunity for them to generate taxable events, thus leading to smaller distributions for many of these funds. If this sounds appealing to you, instead of a fund like Sequoia, you might want to think about dedicating some money to SPDR S&P 500 (AMEX: SPY ) or Vanguard Total Stock Market ETF (AMEX: VTI ) .
Of course, it's important to note that all of this hoopla surrounding fund distributions and the tax implications thereof are only applicable to taxable investment accounts. That means if you own mutual funds in your 401(k), IRA, or other tax-advantaged retirement account, you don't have to worry about any of this -- none of your distributions will be taxed until you begin withdrawing your money after you retire. That's why it's a good idea to put more tax-inefficient investments like bond funds, or any funds that pay out frequent dividends, into tax-sheltered accounts so you don't have to worry about the tax implications of those distributions.
While you should never let the tax tail wag the investing dog, it's important to consider the role that taxes play in your portfolio. If you're a fund owner, you may need to do a bit of sleuthing around year-end to get a handle on the distribution picture, but a few minutes spent now will likely save you a lot of frustration, money, or both down the road.