Year-end Tax Planning

With the end of 2007 just around the corner, it is time to think about some basic tax planning.  The biggest and simplest one for the middle class revolves around realized gains and losses on investments, and mutual funds are generally a component of the average person's investment holdings.  Many mutual funds are estimating that they'll make record distributions to shareholders in 2007, largely due to the gains in the market this year. Investors doing any form of tax planning need to be very careful with these December surprises in mind.

Each year, mutual funds are required to distribute to shareholders their income and net capital gains, or profits on the sale of their holdings. Investors who hold funds in taxable accounts must pay taxes on these distributions, even if the distributions are automatically reinvested. If you buy into a fund just before a distribution, they could end up paying taxes on gains they didn't actually receive.

Some fund experts predict this year's total mutual-fund distributions will be the highest ever. Despite the summer market turmoil, stocks have moved substantially higher this year, creating sizable gains in many funds. As of October, the DOW Industrials was up almost 13%, while the NASDAQ was up even more. 

Last year, mutual funds paid out $259 billion in capital-gains distributions, the highest level since 2000, according to the Investment Company Institute, the fund-industry trade group. Recent surveys by major fund companies show that many are likely to make even larger year-end distributions this year than they did in 2006.  

When investors exit a fund, managers are often forced to sell holdings, booking gains that can be distributed to shareholders.  Based upon this pattern, some of the largest distributions are likely to come from small-cap and value funds. Since these funds have been on a tear in recent years and now are widely expected to fall behind funds focused on larger, faster-growing companies, investors are pulling money out of the category.  Furthermore, due to the continued strong performance of overseas markets, many international funds are also in similar circumstances, but for different reasons.   Foreign stocks in developing economies tend to rise quicker, forcing managers to take gains more quickly.

Let’s not forget this is good news as no one should be upset when they receive money.  Let me conclude with two pieces of advice.  Do not buy any mutual funds between now and the end of the year due to one simple reason; if you buy into a fund just before a distribution, you would be required to pay taxes on the distribution.  Also, do some homework now and find out what type of losses you are sitting on so that you are prepared to sell them on short notice. 

You should also be careful not to violate what are known as the "wash sale" rules.  Although they can be rather complex, in general, a wash sale occurs when you sell a security at a loss and, within 30 days, you buy exactly the same thing or something "substantially identical." That means 30 days before or after the sale. If you violate the rules, the IRS says you can't deduct the loss. 

With that said, happy returns and holidays to all of you.