If you own mutual fund shares outside of your IRA, be on high alert for the tax man. Funds generally announce their required distributions of realized capital gains around this time of year, so you should mind your timing of purchases and sales accordingly to avoid unanticipated tax liabilities.
Investors who buy and sell individual securities understand that they control when to fork over Uncle Sam’s cut of the profits. Capital gains, for example, are recognized based on the date a stock is sold, and are deferred indefinitely as long as the holding is retained (and disappear entirely at death).
With mutual funds, not so much. The rules governing tax treatment of funds demand that certain profits and losses be passed along to investors each year. Typically, capital gains incurred throughout the year inside a mutual fund are distributed in November or December. Investors should make the effort to know when and how much a fund is expected to declare before either buying or selling near the end of the year.
Traditional open-end mutual funds are simply pools of investor cash lumped together to purchase a portfolio of stocks or bonds. During the year, positions are sold at a gain or loss based upon the fund manager’s particular investment criteria. In addition, when investors decide to cash in their shares, the fund must sell securities to generate the proceeds to satisfy redemption requests, again forcing the fund to recognize gains or losses. If redemption requests are especially heavy, the fund manager may be forced to liquidate long-held positions with significant embedded gains to raise sufficient cash.
If the netting of all sales during the year results in a capital gain, the bulk of that gain must be paid out to fund shareholders, even if the holders do not sell any of their shares. This can sometimes come as an unpleasant surprise.