Thursday, December 28, 2006

MUTUAL FUND TAXATION can be confusing. You sometimes get taxed on “phantom profits” even if the fund declined in value. If you exchange Fund A for Fund B, you may be taxed because of the exchange. Ouch!

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Your mutual fund company may offer Fund A and Fund B.
If you buy 100 shares of Fund A at $10 per share ($1000), and a few months later you may notice Fund A has gone up 10% while Fund B has gone up 20%. Then you decide to exchange Fund A for Fund B. So you make the exchange and get $1100 worth of Fund B as a result of the exchange—no cash is involved in the exchange. At the end of the year you get a Form 1099-B showing that you sold Fund A for $ 1100 and have a taxable profit of $ 100. The IRS treats the exchange the same as if you had redeemed the Fund A shares for $ 1100 and received the $ 1100 in cash. You can’t cheat on the cost and claim you paid more than $1000 because the IRS now requires the fund to report both cost and sales on the 1099B (according to something I recently read).

Assume that you buy shares in Fund X for $ 10,000. The fund invests in 100 different stocks giving you the diversification you are seeking. The fund manager keeps an eye on the portfolio and weeds out some of the stocks and replaces them with others he thinks will outperform the ones he dumped. In a rising market, the ones he dumped may have gone up since his original purchase even if they have gone down after the date you bought the fund. What happens to you? You get taxed on those gains even though the fund itself ends the year worth only $ 9,000 --$1000 less than you paid for it.

Another thing will happen in Fund X. A lot of those 100 stocks in the Fund’s portfolio will pay dividends. You may have elected to reinvest the dividends. If the dividends amount to $1000 they are reinvested and added to your basis in the fund. That is, if you sell the Fund you bought for $10,000, you now have a basis of $ 11,000 and if you sold all your fund shares at $10,500 you would have a capital loss. But what if you don’t sell it? That $ 1000 in reinvested dividends is reported as TAXABLE INCOME. Even with those reinvested dividends, the fund may only be worth $9000 at year-end. You have an investment worth $1000 less than you paid for it and you have to pay tax on $1000 that you have never received.

All those phantom profits are added to the basis of your fund, so you end up getting to deduct all those phantom profits when you sell the fund. So, in a sense, it all comes out OK in the long run. The only problem is that you may have paid out a lot of tax before you ever see the color of the money.

There is an exchange traded fund (ETF) equivalent for almost every mutual fund. Instead of buying an S&P Index Fund, you can buy a Standard and Poor Depository Receipt. The symbol on the stock market is SPY. You can buy the NASDAQ 100 ETF if you order it under the symbol QQQQ.. If you are more aggressive, like me, you might order EEB, an ETF invested in BRIC stocks (Brazil, Russia, India and China). Right now China is the big winner, so I recently tweaked my BRIC portfolio by adding 100 shares of FXI which is invested only in Chinese stocks.

PROS AND CONS Mutual Funds vs ETFs
The main advantage of mutual funds is that you can invest small amounts on a regular basis, often by payroll deductions, and there are no fees if you stick to no-load funds. Another advantage is that the fund carries no ‘premium’ over its net asset value; i.e. the value of all the stocks in the fund portfolio.
The biggest disadvantage would be if you invest in a high load fund. There are A shares, B shares and C shares. Some charge a ‘load’ when you buy the fund. Others charge a ‘load’ when you sell the fund, and the load may decline eventually to zero if you hold the fund several years. Any fund with A, B and C categories have loads. A no-load fund does not have these fees. Another disadvantage is a 12b1 fee which is taken out throughout the year to cover expenses the fund incurs in selling and publicizing the fund.
The main disadvantage is that you have to pay a broker fee. However, if you use a discount broker such as E-Trade, Ameritrade or Scottrade, the fee is fairly low if you are buying 100 share or more at a time. There are several advantages. There is no penalty for selling shortly after buying as there sometimes is with a mutual fund. You can check the price any during the day and get the current price whereas a mutual fund must calculate the net asset value at the end of the day and the price is only available after the market closes. You can sell it any time the market is open and maybe even in the ‘pre market’ or after the regular market closes—although I would not normally recommend trading after or before regular market hours. The ETF could sell at a premium or discount to its net asset value. The premium or discount is usually small. NOTE: a closed end fund (CEF) is similar to an ETF, and trade like stocks, but may carry a more significant premium. Currently a fund with the symbol TRF carries a large premium. A similar fund (symbol: CEE) trades at a discount.
You can get high yields in tax fee bonds from some CEFs which may sell at a discount to their net asset value. A list of such funds is available from the ‘successful-investment’ link below. His rankings, etc. for various ETFs and mutual funds are emailed weekly if you subscribe (free).


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This information is not intended to be advice to the recipient. In compliance with Treasury Department Circular 230, unless stated to the contrary, any Federal Tax advice contained in this Blog was not intended or written to be used and cannot be used for the purposes of avoiding penalties.

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