Decoding tax bill for year-end pay-outs

The start of December means D-day for mutual fund investors is fast approaching. That's right -- you may soon be receiving a distribution of income or capital gains. Many funds have a Dec. 15 year-end, so they'll be paying out annual distributions sometime between then and Dec. 31.

Investors who hold funds outside a registered retirement savings plan or retirement income fund might wonder why they have to pay tax on distributions even though they haven't sold anything. Distributions are actually a sign the fund has made money through income earned or capital gains realized -- at least in the long term (more on that later).

If mutual fund trusts didn't distribute all their income and capital gains each year, it would be taxed inside the trusts at the highest marginal tax rate. Because few fund investors are actually in the top tax bracket (which kicks in at about $116,000 in 2005), by having the income and gains flow through directly to investors, the investors pay tax at their own, generally lower, tax rates.

That's enough to justify income distributions -- because if investors held the underlying stocks or bonds, they'd pay tax on the dividends or interest directly. But this reasoning is less satisfactory when it comes to capital gains distributions. After all, if you didn't sell your fund, why should you have to pay capital gains tax?

Keep in mind owning an equity fund isn't the same as owning a single stock. A fund is a basket of securities. When a portfolio manager sells a position at a profit during the year, a capital gain is realized. The same would be true if investors held the individual stocks.

That said, the system isn't perfect, and the possibility exists for an investor to receive a distribution from a fund that has declined in value since it was purchased. This can occur, for example, when a fund's portfolio manager disposes of securities during the year that result in net capital gains (after deducting any capital losses). If the fund held those appreciating securities for several years, and sold them in 2005, the capital gains realized in the current year must be distributed to investors at year-end. Investors who bought into that fund this year may receive capital gains distributions in respect of the fund's 2005 realized gains -- despite the fact they may not have been invested during the period in which the underlying securities appreciated. This is referred to as "pre-paying tax on someone else's gains."

Mutual fund managers use a complicated formula in the Income Tax Act -- the capital gains refund mechanism -- to try to reduce year-end gains distributions. But the formula isn't perfect and can result in capital gains distributions to investors who may not have experienced those gains.

While you may be tempted to switch out of a fund to avoid a distribution, you need to compare the tax cost of the fund with the current fair market value to determine whether you might actually be triggering a bigger tax liability than you would have incurred if you'd received the distribution.

Want to know what your fund is distributing? A survey of the major fund companies conducted earlier this week found that most have already released distribution estimates for their December year-end funds.

Next week: Should you avoid buying funds in December? Myth v. reality.