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Author: Lokicious Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 121061  
Subject: Re: Taxes on fund distributions Date: 1/23/2002 10:22 AM
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"Can someone provide some guidance on paying taxes on year-end distributions from mutual funds and the penalties for owing a large (over $1000 I think) tax bill?
In Dec 2000 my taxable mutual funds had large (unexpected) distributions resulting in a tax bill of over $3000 when I filed my taxes in April 2001. I was not charged a penalty (at least Turbo Tax did not say I owed a penalty and the IRS has not sent me any notices) and I think the reason was because my income in 2000 was significantly higher (just about double) than it was in 1999 and thus my withholdings were double.
Turbo Tax recommended that I make quarterly payments in 2001 to avoid the situation from the previous year. However, I only had $180 in total distributions by years end. I had budgeted a Jan 15 quarterly payment but since the amount was so low I didn't make it. I will continue to get pay raises every year but probably only around 5-10%.
My question is if I continue to get pay raises every year do I need to worry about getting hit with a penalty for underpayment of taxes due from those year-end distributions? I have the appropriate withholding from my wages; I just don't have any withholding for mutual fund distributions.
I hope that made some sense!"

Jim,

Many funds had exceptionally large capital gains distributions in 2000, and exceptionally small capital gains distributions in 2001. If you think about what has happenned with the stock market, the reasons are fairly clear.

1) Many actively managed mutual funds liquidated substantial portions of their holdings at a gain in 2000 to try to escape the bear market.

2) Many investor's sold their mutual funds in 2000, for the same reason, forcing fund managers to sell some of their gainers, resulting in capital gains distributions for those who continued to be invested in the fund.

3) Market volatility in 2000 led to some fairly radical changes in the composition of indices. The effect was not too noticeable with the total market index or the S&P 500 index, but was with mid-cap and small-cap indices. The result was that many stocks, that had gained substantially from when they entered an index, had to be sold for a gain.

In 2001, with the market down, funds did substantial tax loss selling that, in many cases, covered all or most of their capital gains for the year.

There is of course a reason why Vanguard's S&P 500 index fund beat 84% of mutual funds after taxes over the last 20 years, (according to an article in yesterday's Wall Street Journal).

I would suggest you do a lot more research about your fund's investment approach. You might start by using distribution figures from less extreme years—say the average from 1995-1999—to make more accurate estimates for taxes. But you should also try to obtain quarterly distribution figures, especially in years the stock market is particularly volatile. Vanguard publishes distributions for their funds on their Web site every month. I'm afraid many other fund families require more effort to find out about, because capital gains distributions are a dirty little secret—note the effort Motley Fool undertook to force funds to reveal after-tax results, but they are still typically hidden in the fine print.
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