The upside of market downswing

Overall, the last few weeks were good for stock-market investors, though nerve-racking. The Dow Jones industrial average has soared since Oct. 9, but it had some big down days on the way.
It's far from clear that the market is in a sustainable rally. But this much is clear: The wild gyrations and the possibility of a year-end rebound make it especially important for investors to consider the interplay between investment decisions and tax issues.
The good news: If you want to put new money into stock funds this fall, you don't have to worry as much as usual that an untimely move will boost your tax bill come April. Because of the two-year stock market slump, fewer funds will make the devilish year-end capital-gains distributions that have plagued investors in the past.
How it works
Funds are required to pay their shareholders by year-end for the net profits from stocks or other holdings that fund managers sold during the year.
Many investors never receive checks because they choose to have the money reinvested in more shares. But the distributions are subject to capital-gains tax unless the investment is in a tax-deferred account such as a 401(k) or IRA.
This year, though, most funds don't have profits to distribute; most have losses.
"It's the one potential silver lining in all of this equity downdraft," said Joel Dickson, a principal with the Vanguard Group fund company and an expert on fund taxes. Only a couple of Vanguard's 109 funds are likely to make distributions this year, and those will be quite small, he said.
"Right now should be a pretty good time for investors who are concerned about taxes," added Peter Di Teresa, a senior analyst for Morningstar Inc., the fund-tracking company.
So far this year, only 446 stock funds have paid distributions, compared with 923 at this point last year and 1,354 at this point in 2000, Morningstar says. The average distribution to date is 1.75 percent of share price this year compared with 2.70 percent last year and 4.75 percent in 2000.
All in the timing
A savvy investor can avoid the tax bite with careful timing. Imagine you paid $10 per share for a fund that later paid out a distribution of $1 per share. You would have to pay tax on that distribution at rates ranging from 20 percent to 38.6 percent.
To avoid this tax, the investor could postpone the fund purchase until after the distribution. All else being equal, the shares could then be bought for $9 each, since the price would drop to represent the money paid out of the fund. If you don't get the distribution, you don't pay the tax.
Two factors make capital-gains distributions less of a problem in 2002.
First, many investors sold fund shares or other assets at a loss, which will offset the gains from any distributions. When you do your tax return, all your gains and losses are combined to get the bottom line -- and overall loss or gain for the year.
Second, because of the stock slump, fewer funds will make distributions -- most of which come in November and December.
Managing losses
Unfortunately, a fund's capital losses are not distributed to investors the way gains are, so they don't bring any immediate tax relief. But losses do remain on a fund's books and can be used to offset any gains as long as eight years.
An investor who wants to put new money to work in stock funds now probably needn't worry too much about a potential capital-gains tax, though it would pay to question the fund company before investing.
Thankfully, it looks as if taxes needn't be much of a concern this fall. All you have to worry about is how the market will perform -- and that's plenty.
XJeff Brown is a business columnist for The Philadelphia Inquirer. E-mail him at jeff.brown@phillynews.com.