How Mutual Fund Losses Can Offset Taxes

If you are a mutual fund investor, you know that the 2008 fiscal year hasn’t given you a whole lot to be happy about. Recent downturns in the economy and plummeting stocks prices have resulted in large realized losses for most mutual fund accounts. However, as tax time rolls around, you may be surprised to find that your mutual fund losses can result in a nice tax break on your mutual fund that pays you back for years to come.

How You Can Offset Fund Losses

Here’s how it works: when you invest in a mutual fund, your investment vehicle is considered taxable. Unlike a tax-exempt 401K, your mutual fund portfolio gains and losses are subject to capital gains tax when your portfolio manager sells off securities that have appreciated over the course of the year. Each year, mutual funds are required by law to distribute what’s called “realized capital gains” to their investors. As opposed to holders of individual stocks, who pay taxes only when they sell their stock, your mutual fund may present you with an annual tax bill based on your stock portfolio’s realized net gains and losses.

Positive News for Fund Investors Who Lost

Now, here’s the good news: for stock funds that now have a large negative capital gains exposure – meaning that losses on the account exceed gains for a given period – those realized losses can be carried forward for up to eight years, and used to offset realized gains during that period. Which means that if you are participating in one of the many mutual fund stock portfolios that lost money last year (when the average diversified US stock fun lost around 40%), you may have a pretty hefty tax loss to carry forward over the coming years to offset the tax on any future stock gains.

What If I’m Not Invested In Any Funds at the Moment?

Don’t have any investments in mutual funds right now? Even if you are a new buyer in an existing mutual fund stock portfolio, you can still benefit from that fund’s losses from last year, under certain circumstances. If stocks in the portfolio are trading for less than the fund paid for them, they are still considered a negative potential capital gains exposure and will probably continue to become “realized losses” to that fund over the course of the next year. For instance, one formerly quite profitable mutual fund is projected to lose over 300% in capital gains by the end of March; other US and international mutual funds are looking at potential loss carryforwards of over 100%. Low stock valuations and loss carryforwards can look like a negative on the books, but as stock values recover, this negative can be a positive in terms of capital gains tax exposure on your investment. For many investors, this historic opportunity can make a mutual fund an attractive alternative to a tax-deferred 401K over the next few years.

Of course, if you are shopping for mutual funds, you shouldn’t make your decision solely on the basis of tax losses. Analysts agree that you should look for a mutual fund with a solid history of returns and good management before investing your hard-earned cash in a fund with negative capital gains. However, if you are interested in knowing what a fund’s capital gains exposure is likely to be, you can generally see it in the fund’s annual report in an analysis report for the mutual fund. Or, you can just contact the fund directly.