If there a bad time to buy Mutual Funds? - 7/07/08

INTRO: Today mutual funds are probably the most popular investments.  But before you run out to make a purchase, make sure you understand that there are good and bad times to buy mutual funds. 

1. IS THERE A BAD TIME TO BUY MUTUAL FUNDS?

A. Yes.  And to understand why, you need to understand how mutual funds are taxed.  Generally mutual funds distribute interest monthly and dividends quarterly.  But they typically wait until December to distribute capital gains.  Capital gains are the profits made during the year by selling holdings in the fund.

Even in years when the total value of the fund went down, the fund is likely to have capital gains to distribute.  If a particular stock in the fund is sold at a higher price than that stock's original purchase price, then that's a capital gain which must be distributed to the owner of the fund.  Even if the overall value of the fund went down for the year, you'll get a distribution of the capital gain for that particular stock.

2. CAN YOU GIVE US AN EXAMPLE OF THIS?

A. Imagine your fund bought a security in 1997 for $15 a share. At the start of 2000, the security was worth a total of $30/share, but the fund ended up selling the security for only $25/share. This is a loss for the year, but an overall profit of $10/share.

Example:

1997 = $15/share

Start 2000 = $30/share

Sold security for $25/share

Example:

B. Another possibility would be for the fund to sell the security for $35/share, which is a gain even for the most current year, but the rest of the fund's holdings went sour and created a losing year for the fund. This fund would still be forced to pay out capital gains on the security that they sold.

3. SO WHEN IS IT A BAD TIME TO BUY A MUTUAL FUND?

A. Typically, the worst time to buy is right before the capital gain is declared for the year, in December.

4. WAIT A MINUTE: I F YOU BUY RIGHT BEFORE THE CAPITAL GA In IS DECLARED AND PAID, DON'T YOU GET THE DISTRIBUTION?  ISN'T THAT GOOD?

A. It's true that if you buy a fund right before the distribution, you get that extra money.  But you'll have to pay tax on the distribution at your regular income tax rate, which is higher than long term capital gain rates.

5. BUT WON'T YOU STILL COME OUT AH EAD, BECAUSE IF YOU GET A $100 DISTRIBUTION, AND PAY $30 TAX, YOUR STILL $70 A HEAD?

A. Actually, you're usually better off buying the mutual fund after the capital gain distribution.  That's because the share price of the fund will be less because the price of the fund will be based on the lower amount of assets in the fund after the capital gains have been distributed.  So you get more shares for less.

I know this sounds complicated.  And that's because it is.  But buying a mutual fund right before the distribution is usually worse than buying right after.

6. [IF TIME] WHAT IF MY MUTUAL FUND IS AN IRA OR 401(k) PLAN?

A. Taxes do not affect a non-taxable account. Uncle Sam will have to wait until you start taking money out of these accounts (the Roth IRA is an exception).

CLOSE: Timing your mutual fund buys correctly today can save you tax money tomorrow.