Talk about kicking investors when they're down.
A required year-end practice by mutual funds is about to whack many people with capital gains taxes at the cruelest of times: when funds already have declined by as much as 40 percent this year.
Even though a fund's value has declined, it may have realized capital gains over the course of the year – profits from selling specific securities in the portfolio.
When individuals find out they have to pay taxes for gains in one of the worst years in stock market history, it's likely to stir shock or outrage among those who pay little attention to the process.
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After all, 99.9 percent of all U.S. equity open-end funds had negative returns for 2008 through Oct. 31 and the average fund had lost 35 percent, according to Morningstar Inc.
Getting stuck paying capital gains even when your funds decline in value is rare but not unheard of.
Still, how could it happen?
The Internal Revenue Service requires mutual funds to distribute substantially all (at least 98 percent) of their income to their shareholders, who must then report the distributions as income and pay taxes on them. This year, funds realized gains from stocks sold before their value plummeted this fall.
Then when the financial crisis hit, investors pulled a record $46.5 billion out of U.S. mutual funds in September and another $40.5 billion in October, according to Arcata, Calif.-based AMG Data Services. The forced selloff led funds to record significantly more capital gains.
If your fund investments are in tax-sheltered retirement vehicles such as 401(k)s or IRAs, you needn't be concerned because there are no taxable distributions. But shareholders of other funds face what could be a significant double whammy with ill-timed distributions on top of their whopping personal losses.