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MUTUAL FUND HOLDERS MAY GET TAX SHOCK; MANY WILL HAVE TO PAY ON CAPITAL GAINS EVEN THOUGH SHARE PRICES HAVE FALLEN

IT IS happening again. It is happening again.

No, that's not the giant on Twin Peaks warning of another horrible murder. Rather, it is a warning to owners of mutual funds that invest in stocks.

Their last dreadful experience came in 1987, when the stock market rallied strongly through August, then collapsed in the great October crash.

First, many mutual fund investors ended up the year with shares that were worth far less than they were at the beginning of 1987.

Then, when they began to do income tax returns in early 1988, they got a second shock: They had to pay taxes on big capital gains distributions made during 1987 by their funds.

A lot of investors were understandably dismayed at having to pay taxes on investments that had lost money.

Unfortunately for those investors, 1990 is turning into a replay of 1987.

It all stems from the quirky tax laws that apply to mutual funds.

Whenever anyone sells a stock, bond, or other investment and makes a profit, they must pay income tax on that gain.

Big mutual funds buy and sell hundreds of investments each year and make big money on some of those sales.

But they don't pay taxes on their gains. By law, they pass the tax liability directly to their shareholders each year in the form of capital gains dividends.

If the mutual funds receive any income dividends or interest on their investments, they pass those on to shareholders each year through income dividends.

It may sound paradoxical, but in years like 1987 many funds had big gains. They bought and sold lots of stocks before the market crashed, and made lots of money on those sales.

In addition, some sold stocks after the crash in order to raise enough money to pay off shareholders who were fleeing the funds.

It is likely that many of those stocks had been purchased years before and even after the crash were worth more money than when they had been bought, meaning the funds recorded capital gains on those sales as well.

This year resembles 1987, though on a gentler scale.

The stock market was up through the first half of the year, with the Dow Jones Industrial Average reaching an all-time high of 2,999.75 in July.

From there the market plunged swiftly and deeply as reality about the state of the economy set in and Iraq invaded Kuwait.

Stocks have recovered somewhat since then but still are lower than they were at the beginning of the year. The average stock fund has done slightly worse than the market during this period.

Even though the funds have declined in value, they made money selling stocks during the year and some of the funds are making big capital gains distributions this month.

Holders of the Vanguard Windsor Fund, the second-largest stock fund, will have to pay taxes on capital gains distributions of 32 cents per share and income dividend distributions of 74 cents per share.

But the value of their shares, including the dividends, has declined by about 15 percent so far this year.

The largest stock fund, Fidelity Magellan, distributed capital gains and income dividends in the spring and again in December. The total distribution is worth $3.25 per share.

Its shareholders will pay taxes on that amount, even though their investments have declined by about 5 percent so far this year.

When shareholders sell their shares, they will get some consolation for all the pain they are suffering now.

Because they already have paid taxes in advance on these gains, shareholders who regularly reinvest their dividends in new mutual fund shares may end up paying no taxes when the shares are sold, or have a tax loss that can be used to reduce the tax on other capital gains and up to $3,000 of ordinary income.

Here's how this works: To determine a gain or loss when selling an investment, you subtract the purchase price from the selling price. If you buy a stock for $5, and sell it for $8, you have a taxable gain of $3 ($8 minus $5).

If you have reinvested your mutual fund dividends in new fund shares, as many shareholders do, you add the value of those dividends to the purchase price before subtracting that amount from the selling price.

So if your original mutual fund share cost $5, and over the years you have reinvested dividends worth $2, your "basis" price is $7 a share. Subtract that from the $8 selling price and you have a taxable gain of only $1 to report to the Internal Revenue Service.

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