The effect of a capital gain distribution on a fund’s price

If your fund is down when the market is up, the fund might have just paid a capital gain.

·           What is a capital gain? When you sell a capital asset — such as a stock or a bond — for more than you paid for it, you make a profit, or experience a capital gain. So if you buy a stock for $100 and later sell it for $120, your capital gain is $20.

·           Why do mutual funds pay capital gains? When a mutual fund sells a holding, it receives any profit, or capital gain, that results from the sale. Mutual funds are required by law to pay virtually all gains to their shareholders in capital gain distributions. These distributions, which typically occur once or twice a year, are made primarily for tax reasons.

·           Why does the fund price drop when capital gains are paid? Fund managers buy and sell securities throughout the year, sometimes at a profit, sometimes at a loss. When profits outweigh losses, they accumulate and contribute to the rise of the Net Asset Value (NAV) of the fund’s shares. When that profit is paid out to shareholders — as the capital gain distribution — its NAV, or share price, will be reduced by the amount of the distribution.

However, if you reinvest the distribution, as most shareholders do, the number of shares in your account will increase proportionally, so that the total value of your account will not be affected by the distribution.

·           For example… Say a fund share sells at an NAV of $10. If sales of the fund’s securities have realized a profit of $2 a share during the year, a capital gain distribution of $2 will be deducted from the NAV on a specified date, so on that date the fund share price will decline to $8.

·           Don’t worry — you haven’t lost any money. You still have $10 in value — $8 in the fund’s Net Asset Value, and $2 in your pocket or reinvested in the fund. And if you do automatically reinvest your capital gain distribution, it buys you additional fund shares at the new, lower price of $8. These additional shares compensate for the drop in the NAV, so the total value of your account doesn’t change. (Of course, if there is a decline in the market at the same time, you may still see a drop in the total value of your account.)

·           For example… If you have 100 shares in your account when the NAV is $10 a share, your account value is $1,000. If the fund pays a capital gain distribution of $2 a share (or $200, since you have 100 shares), the NAV drops to $8 a share and your original 100 shares are now worth $800. However, if you automatically reinvest your capital gains, the $200 distribution buys you $200 worth of shares — at $8 per share. The distribution therefore adds 25 shares ($200 divided by $8) to your account, so you now own 125 shares worth $8 each, for a total of $1,000, which was your original account value before the capital gain was paid.

 I've gotten a few phone calls from people who are watching their investment accounts and they have asked me about why the value drops on what seemed to be a "good" day. This is one of the most common reason: capital gain distributions, dividend distributions, special dividends, etc. By the time they get their statements at the end of the month, the whole issue is made clear. Call me if you have questions on your own account.

Charitable Contributions from Your IRA

New tax rules for IRAs have recently been enacted. Up until the end of 2007, if you are charitably inclined and wish to give some of your IRA funds to a church or a charity, you can withdraw up to $100,000 from your IRA tax free and give it to the charity directly. You receive no tax deduction but also do not have to report the income. This new provision allowing Qualified Charitable Distributions only applies to IRA owners over the age of 70 ½, and only applies to outright IRA gifts to charities, not gifts made to grant-making foundations, donor advised funds or charitable gift annuities.

The big incentive here is that the charitable donation from your IRA will satisfy your minimum distribution requirements. While all taxpayers over age 70 ½ are required to take minimum distributions from their IRA, they won't have to pay tax on the amount of the required distribution that they give to charity. This can lower your income and maybe even cut down the tax you pay on Social Security income, not to mention the loss of tax deductions, exemptions and tax credits that are lost when your income is increased. So, if you normally make donations anyway, you should now make those donations (through 2007) from your IRA and reduce your taxable income.

This provision is especially good for those who do not itemize their deductions (they take a standard deduction) and would not normally be able to deduct gifts to charity (unless the donations were large enough to qualify for itemizing deductions). By not having to report the income from the IRA distribution, you effectively receive a deduction that would not otherwise have been available to you.

However, there’s a technicality here that financial institutions will have to address so that your contribution qualifies. Under this provision, the donation must be made DIRECTLY from your IRA to a charity without you or anyone else touching the money in between.

If you think that this tax-saving technique is appropriate for your contributions to your favorite charity, you should discuss this with me as soon as possible at 860-521-4751.

August 17th: President Bush Signs the Pension Protection Act of 2006 ("the PPA").

While the new law of over 900 pages mainly deals with relatively arcane retirement-plan provisions, it also includes important tax changes that will directly affect many individuals, small businesses and charities. Here is one of the key points, that I know will affect my clients:

Beginning in 2007: More Beneficiaries Can Roll Over Money from a Deceased Person's Retirement Plan: Under the current rules, only an individual who is a deceased person's surviving spouse can rollover, into his or her own IRA, distributions received as a beneficiary of the deceased person's qualified retirement plan (like a 401-k plan).

Other beneficiaries (such as children, grandchildren, and other relatives or unmarried partners) can't take advantage of the tax-smart rollover strategy. But things now change.

Beginning next year, a nonspousal beneficiary will be allowed by the IRS to receive a tax-free rollover (actually, a direct transfer) of a qualified distribution from a deceased person's plan, even if that person died several years ago. The plan too must allow for this to happen.

For this taxpayer-friendly treatment to apply, however, the money must go directly into the receiving IRA via a trustee-to-trustee transfer. And it must go to a separate account created for this purpose, called a "Beneficial IRA". The Beneficial IRA is also known as an "Inherited IRA" and it is maintained in the name of the deceased plan participant (e.g.: "Uncle Ralph's IRA, deceased February 15, 2007, FBO Neice").

The beneficiary may not co-mingle this distribution into an already-existing IRA that he or she may have had; doing so will cause the transfer to become enirely taxable. But this Beneficial IRA preserves the "Stretch" IRA concept for the beneficiary.

So don't let your dear departed Uncle Ralph's plan make out the check to you personally. If that happens, you can't roll the money over, and you'll owe taxes on what you receive.

Ralph's Funeral

Roth Conversions Are Making A Big Comeback!

On May 17, 2006, President Bush signed the Tax Increase Prevention and Reconciliation Act of 2005 into law.  This tax bill included a provision dealing with conversions of traditional IRAs to Roth IRAs.  Starting in 2010, the existing $100,000 income test for converting a traditional IRA to a Roth IRA will no longer apply.  Conversions that occur in 2010 will be able to have half of the taxable converted amount taxed in 2011 and the other half taxed in 2012. 

Remember that a Roth IRA is worth more than a conventional IRA because withdrawals from it are forever tax-free. Roth IRAs have been described as the greatest retirement plan ever.

Under current law, distributions from a Roth IRA are tax-free if distributed after age 591/2 and after the account has been open five years. What's more, there are no required minimum distributions during the lifetime of the Roth IRA owner.