Funds Forecast Higher Distributions

Funds have to pay out 98% of any gains or dividends at least once a year. Most do so in the fourth quarter. Investors with funds in nontax-deferred accounts have to deal with them on their tax returns.

One key factor this year, fund groups agree, is that stock funds have used up most or all of their capital loss carry-forwards from the 2000-02 bear market.

"In our case, most nontech funds have used up their carryovers," said Sam Beardsley, director of investment tax for T. Rowe Price. "Tech funds still have them and aren't distributing."

Another factor is a strong market. Many funds have had sizable gains.

"That's especially true in emerging and international markets," Beardsley said.

Natural resources funds were up 40% on average for the past 12 months, going into Wednesday, according to Morningstar. Funds focused on Asia exclusive of Japan soared 89%. Latin America funds cha-cha'd ahead 64%.

Many funds have chosen or have been compelled to take profits along the way. For example, $1.6 billion T. Rowe Price Emerging Europe & Mediterranean Fund (NASDAQ: - ) is on tap to pay out $3.62 per share this year.

Distributions per share by T. Rowe Price stock funds are currently expected to climb by 40%, Beardsley says. They should average $1.49 per share, or 5.3% of an average NAV, up from $1.05, or 3.7%, last year.

Final numbers could change as portfolio managers continue to take gains as well as losses that can be used to offset gains.

Money Magnifier

Price's figures are based only on capital gains, which constitute the bulk of distributions by stock funds industrywide. Dividend distributions could boost the totals.

That's most likely for large-cap funds. Dividends paid by stocks making up the S&P 500 are expected to climb 12% this year, according to Standard & Poor's. As usual, smaller stocks are expected to pay less.

"Dividend initiations and dividend increases continue to slow down," said Howard Silverblatt, senior index analyst at S&P. "A big reason is increased corporate buybacks."

Some fund groups are forecasting more modest distribution hikes. AIM Funds says shareholders can expect slightly higher distributions as a percentage of NAV.

American Century distributions should be higher this year, but not by a lot, says Robert Leach, vice president and director of fund accounting for the complex.

An increase in fund distributions industrywide would extend a trend that began in 2002. Capital gains and dividends rose each year after 2001. Cap gains alone in 2006 were $456.9 billion, according to the Investment Company Institute. That was better than double 2005's $217.1 billion.

Gains plus dividends totaled $575.7 billion last year. That was up from 2005's $301.7 billion.

Individual funds that are expected to boost payouts a lot this year may be barometers for entire categories.

In addition to funds focused on commodities and emerging markets, fund groups expect value funds' payouts in general to rise more than growth funds' this year. Growth funds should be able to offset more gains with loss carry-forwards, says John Woerth, spokesman for Vanguard Group.

Small- and mid-cap value portfolios should also have fewer offsetting losses, Beardsley says.

Many shareholders are reluctant to buy fund shares late in the year. They are wary of having to pay tax on gains in which they haven't participated.

"But taxes shouldn't be your primary concern," Beardsley said. "If you're out of the market, you can lose far more by missing price gains than you'd lose in taxes."

In recent years, 50% to 71% of cap gains distributions were in tax-deferred accounts.

Out Of Action

Still, shareholders may risk another drawback to year-end distributions. "A portion of your purchase price is paid to you in the dividend," Beardsley said. "Unless reinvested, that money is not invested in the market, but you're taxed on it."

If you recently bought a fund in a nontax-deferred account and it's likely to pay out cap gains or a dividend but that hasn't risen much, you may be tempted to sell.

If you sell shares to avoid distributions, beware of the wash-sale rule. You can't buy them back within 30 days. Any loss you realize in the sale would be disallowed as a write-off.

And if you sell winners, consider harvesting some losses too. Offsetting losses will cut your tax bill.

"If you take excess losses, you can deduct up to $3,000 of it against ordinary income," Beardsley said.

Be careful about selling shares of a fund closed to new investors. If you're a long-term investor, you may be shut out of a top performer.