Beware the Coming Tsunami of Mutual Fund Distribution

Editor's note: This is the transcript of Kiplinger Editorial Director Kevin McCormally's 2007 year-end tax tips series on The Nightly Business Report.

SUSIE GHARIB: The calendar may say [December], but we're thinking April, as in the mid-April deadline to file your Federal income taxes. Now is the time to look over your finances and find ways to keep more of your own cash. And we're here to help all week long with our year end tax tips. Tonight, our tax expert, Kevin McCormally, editorial director of "Kiplinger's Personal Finance" says beware the coming tsunami of mutual fund distributions.

KEVIN MCCORMALLY, EDITORIAL DIR., KIPLINGER'S PERSONAL FINANCE: Mutual fund investors brace yourselves. Funds are about to begin doling out billions of dollars in year-end distributions. By one estimate this year's largesse will surpass last year's record of $481 billion. We could even break the half-a- trillion dollar mark. That's sweet. And it can also bring both tax headaches and opportunities.

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First the headaches: it threatens investors who buy a fund just before a payout. That might seem pretty smart -- after all, you get a full-year's income even if you've owned the fund for just a few days. But it's really a blunder. When the distribution is paid, the share value falls by the same amount, a $10 pay out knocks $10 off the share price. Recent buyers effectively get a rebate of part of the purchase price. The bad news is you have to pay tax on that refund. You're better off buying just after the ex-dividend date rather than just before.

Now, for the opportunity: if you're planning to sell a fund soon, you're probably better off doing it before rather than after the distribution. Remember, what's being paid out may be a combination of long-term gains realized by the fund this year, short-term gains, interest and dividends. Before the payout, it's all built into the share price. So if you've owned the fund for more than a year, all of the profit on the sale will be treated as a long-term capital gain, taxed at a maximum rate of 15 percent. If you sell after the payout, you'll have less gain to report since the share price falls. But part of the distribution -- the part that represents short-term gains, non-qualifying dividends and interest -- will be taxed as high as 35 percent. Selling sooner rather than later lets you dodge that inflated tax bill. I'm Kevin McCormally.

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