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What You Should Know About Year-End Distributions

Dated-November 2016

Every fall investors are cautioned about inheriting a tax bill by buying mutual funds about to make large year-end capital gains distributions. Buy afterward and you can avoid an ugly surprise.

But all years are not created equal. Sometimes distributions are big; others, not so much.

How's this year shaping up? Overall it won't be too bad, but "there are a handful of doozies," Christine Benz, director for personal finance at Morningstar, recently wrote in a report.

So investors are wise to check with the fund company before buying. Many have already posted distribution estimates on their website. And if big distributions give you headaches at tax time, it could make sense to rejigger your portfolio to minimize the problem in the future.

 
 

Many mutual funds pay dividends throughout the year, and lots of investors have them automatically reinvested in the fund. But the year-end payments can be especially large. They are the net profits the fund has realized from holdings sold during the year, and the government requires they be paid to investors by year-end.

If your fund is in a tax-favored account like an IRA or 401(k), it's a non-event, because you don't pay taxes until you redeem shares to make withdrawals, which may be decades later. But if the fund is in a taxable account, the distribution is subject to long- or short-term capital gains tax, even if the payment is reinvested. Using a portion of the distribution to pay the tax means reinvesting less, and that hurts your compounding over the years.

And sometimes the payments are whoppers that require the investor to come up with lots of cash to pay taxes the next April.