Be prepared to pay capital gains even if mutual fund lost big Gail MarksJarvis Chicago Tribune November 5, 2008 Just when you thought your mutual fund losses couldn't get any worse, your fund might be about to add insult to injury. During the next few weeks, many mutual funds are expected to deliver some unpopular news to investors: You will owe capital gains taxes in April, even though your mutual funds might have lost thousands of dollars of your money in a plunging stock market. You might wonder how that could be. Typically, when an investor is holding a losing investment, they don't owe Uncle Sam any taxes on it. But mutual funds held in taxable accounts can be a different matterâespecially during years like this, when the average mutual fund has lost 33 percent of its value. Because investors are becoming discouraged about their losses, mutual fund managers are being forced to sell some of their best stocks to raise cash for the investors who are fleeing. That means the mutual fund incurs a capital gain on profitable sales of stock. Under federal law, those gains, plus dividends, must be passed on to the people who have money in the mutual funds. They are called "distributions," and must be reported on tax returns. People with money in 401(k)'s, IRAs and other accounts that are not taxed don't have to worry about the gains. But for others, the distributions are likely to come as a shock. Many fund managers try to limit the possibility of capital gain distributions by pairing losses and gains on the stocks they sell. Under tax laws, when an investor sells an investment at a loss, that can cancel the effect of selling another at a gain. But in the current market, some managers face limited choices. Investors have been leaving mutual funds in huge numbers. When they do that, the fund must give them cash. In September, investors pulled $49 billion out of funds, according to Morningstar Inc. Because the average U.S. stock fund had less than 5 percent of the portfolio in cash, managers had to sell stocks quickly. While few fund companies have reported distributions yet, the notices generally are provided in November and December. They are often posted on Web sites. Sometimes investors try to anticipate the distributions and leave funds in advance to avoid declaring the gain at tax time. But Kay Thomas, who provides tax advice at Fairmark.com, said most people gain nothing by selling to avoid taxes on capital gains. "If you sold now, the gains would be in the sale price, so you already have a piece of it," he said. Larry Kuhl, a Lake Bluff financial planner also cautions investors about allowing tax concerns to drive investing decisions. He does not think it's wise to sell a mutual fund now after sustaining significant losses. And removing money from one mutual fund and investing it in another this time of year can cause tax issues. Investors who put money into mutual funds just before distributions are announced will be responsible for paying taxes on the capital gains and dividends even if they weren't in the fund when the gains occurred. Morningstar analyst Christopher Davis said it's difficult to anticipate which funds will have large distributions, although index funds are less likely. He suspects the most likely candidates will be international funds and emerging market funds. They were huge winners and attracted hot money. But with recession concerns, they have nose-dived.