Q. I would really appreciate a "plain English" explanation of a situation that I have been trying to figure out for some time now vis-à-vis my tax expectations on my mutual fund earnings. My wife and I started a mutual fund portfolio with the Janus funds several years ago, and I am pleased to say that it has consistently grown in value and continues to look like a very good investment. We have an automatic purchase that continually adds shares to the 4 different accounts and we have our capital gains and dividends reinvested automatically. We also purchase additional shares periodically when we get some cash built up in the checking account.

My question concerns the "real value" of the account at any given time, specifically with regards to the tax liability if I were to "cash out." I would specifically like to know how the potential tax liability of additional growth shows up.

---J.B., Seabrook, TX

  

A. This issue is probably more vexing to mutual fund investors than any other, with the exception picking a losing fund. When you buy shares in a fund, your money is added to a portfolio that is constantly changing in value. By law, mutual funds must distribute all realized dividend and capital gain income each year--- and that's the tax liability that you get when you receive your form 1099 from each fund.

Regardless of when you purchased your shares, or at what price, your will receive year-end distributions that reflect what happened to the portfolio during the year. That's why many people don't buy shares toward the end of the year: the shares they bought may be unchanged in value, but they could receive a taxable capital gains distribution and have to pay taxes on it. If every fund realized all capital gains every year, there would be no other tax considerations.

Most funds, however, don't realize all gains every year. Some realize virtually none in spite of large increases in net assets per share. These funds have large "unrealized capital gains" which will someday be realized--- and become a tax liability. Here's an example: suppose you bought shares of a fund several years ago for $10 a share. This year the fund is worth $20 a share so your shares have an unrealized capital gain of $10. If the fund managers decided to realize sell all their stocks and realize all capital gains, they would have to distribute a $10 capital gain, per share, at year-end. Similarly, if you decide to sell the shares, your capital gain would be the difference between your $10 per share cost and the $20 a share selling price, $10 a share.

The hard part is that you didn't buy shares just once. You've got shares purchased at different times (and at different values) plus shares acquired through distributions. Each transaction has a different tax liability. If you use the average cost basis information provided by the mutual fund company, you may inflate your tax liability.

Before you get mad and start thinking that someone invented all this just to make you crazy, remember this: one of the biggest benefits that mutual funds have provided to the general public is ease and convenience in investing. You can buy shares at any time in almost any amount. Exercising that convenience, however, means that we also have a lot of tax record keeping. One of the reasons we like qualified tax deferred plans so much is their tax simplicity: you don't pay taxes until money is taken out, then all money is taxed at ordinary income rates.

  

Q. I am considering changing jobs/companies and am looking at my pension benefit. I am currently 50 years old, have 30 years with my present employer, and have a defined benefit pension that is estimated to pay me about $1,258 a month at age 60. In addition, I have about $410,000 in a 401(k) plan. The new position would include a 40 percent increase in salary but the new employer does not have a defined benefit pension plan although they do have a 401k and a stock purchase plan. Should the absence of a pension plan be a factor in my decision?

---J.C., by e-mail

  

A. Yes, it should. If two people had identical work and salary histories except that one worked for only one company while the other worked for two, the person with two employers would have a lower pension benefit. Worse, the greater the number of job changes, the lower the total pension benefit compared to the fellow who sticks with the single employer. As a very rough rule of thumb, you need about a 20 percent increase in salary just to overcome the loss associated from moving from one defined benefit pension employer to another. When you give up the defined benefit pension altogether, you would need an even greater raise to offset the loss of the pension.

If you were 25 or 30, the 40 percent increase would offset just about anything. Your move may be a lot more lateral than it appears. This is worth a visit with a savvy CPA who can show you the difference with specific figures.