Money & Investing: Many funds are expected to deliver taxable gains
NEW YORK >> Never mind that this year has largely been a dud for stocks. A tax bill is still coming for many mutual-fund investors.
Now that December is here, funds are lining up to pass along something called a capital-gains distribution to their shareholders. It's about as appetizing as it sounds.
Investors who hold mutual funds outside a 401(k) or another tax-advantaged account must pay taxes on these distributions, even if they don't sell any shares. And the bills could be big: More than a dozen funds have already said they expect to pass along distributions in coming weeks that are more than 30 percent of their total assets.
Several factors are behind this year's distributions, from home-run stock picks made years ago to the recent surge in corporate takeovers. But first, a reminder on what causes distributions and how they affect investors.
When a fund sells a stock, it records how much it made or lost on it. At the end of the year, it totals the gains it made from trading and distributes those gains to shareholders.
Say you hold a mutual fund whose shares currently trade at $10 each. That fund may distribute $2 per share in capital gains to you at the end of the year. You have to pay taxes on those gains if you hold the fund in a taxable account, even if you didn't sell any shares. Long-term gains generally qualify for lower rates than short-term gains.
The value of your holdings won't normally change as a result of the distribution, which often gets reinvested in the fund. The price of each fund share in this example would drop to $8 when it made the distribution of $2, leaving you with the same $10 per share.
The Fairholme Fund expects to make distributions of $11.55 to $12.35 per share next week. That's equal to about 35 percent of the fund's assets, as of Wednesday, and would dwarf last year's distribution of $3.08 per share.
The main reason for the jump is that AIG did what shareholders hoped it would after Fairholme Fund bought it in 2010 and 2011: It surged. AIG generated more than $2 billion in gains for the fund by June of this year. And when it sold AIG shares, it recorded a big gain.
Another reason for this year's rise in distributions is the explosion in corporate takeovers. Companies are finding it difficult to drum up revenue growth given the still-tepid global economy, so they're buying competitors instead. Others are combining in cross-border deals to lower their tax rates.
At the Jensen Quality Growth Fund, managers expect to pass along distributions of $3.74 per share, which is about 9 percent of its total assets, as of Wednesday. Last year's was $1.63.
Earlier this year, one of its investments, Medtronic, completed its $42.9 billion acquisition of Covidien. The deal created a tax bill. The fund also recorded big gains from sales of other holdings.
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