In 2001, many mutual fund investors are learning an unpleasant lesson in tax law. You may owe tax on capital gains, even after a year of losses. According to Morningstar Inc., Chicago, the average large-company growth fund lost more than 14% in 2000. Thus, if you began 2000 with $10,000 in an average fund in that category, you would have wound up the year with less than $8,600.
Nevertheless, most large-company growth funds made substantial capital gains distributions to their shareholders. That’s because the funds took trading profits, which must be passed through to shareholders. Thus, when you filed your 2000 returns (or when you eventually file, if you requested an extension), you owed tax on those capital gains distributions, unless the funds are held in a tax-deferred retirement plan. That’s true whether the distributions were collected or reinvested in the fund.
In some cases, those distributed capital gains were short-term so ordinary income rates apply, up to 39.6%. Many investors, therefore, wound up owing thousands of dollars in tax, even after suffering a large loss of principal in 2001. To avoid a repeat performance, consider investing in a “tax-managed” mutual fund that avoids such distributions, such as Eaton Vance Tax-Managed Growth (800-225-6265) and Vanguard Tax-Managed Growth and Income (800-662-7447).
