by Archie M. Richards, Jr., CFP^®
November 7, 2005

Terry writes, "I want to make a significant investment in an index fund. But I've heard that one shouldn't buy a mutual fund near the end of the year, because of incurring capital gains. Is this true?"

With index funds, you're okay, Terry. The problem you cite applies to actively-managed mutual funds and can occur any time of the year. Here's an explanation:

Assume your neighbor buys shares of a mutual fund early in the year. At about the same time, the fund purchases stocks, which rise nicely.

A year later, your neighbor sells his shares for a profit. At about that time, you buy shares of the same fund.

A few days after your purchase, the fund sells the profitable stocks.

When the stocks are sold, your neighbor is no longer a shareholder. The capital gains are therefore not allocated to him. (If he sells his shares for a profit, he incurs capital gains on his sale of the fund, but not on the sales of stock realized by the fund.)

It's different for you. When the mutual fund sells the stocks for a profit, you are indeed a shareholder, and the capital gains are allocated to you. You must pay tax on appreciation that benefited your neighbor.

Here's where your yearend concern came from: At the end of 1999, many people bought "hot" mutual funds that had already risen a lot. Early in 2000, the funds sold stocks for big profits. The capital gains were allocated to the new investors, even though they suffered big losses when the funds turned cold during the subsequent recession. The investors paid heavy capital gains taxes despite incurring big-time losses.

That misfortunate happened to investors who bought in late-1999, followed by sales in early-2000. But mutual funds can incur profits any time. Don't hold back from buying at yearend. As long as you avoid hot investments, the time to buy stocks is always when you get the money.

You say you intend to buy an index fund. Good idea. Index funds (and exchange-traded funds) are special. Here's why:

Index funds don't do stock research in an effort to pick winners. They don't guess what the market's going to do. They just buy and hold the stocks that are included in whatever index they're tracking.

As an example, the Russell Company, an investment firm, publishes an index of all small U.S. growth stocks. It determines which stocks qualify as small growth. It doesn't buy them; it publishes an index that reflects how the stocks are doing. If small growth stocks collectively rise by one-quarter of one percent, the index also rises by one-quarter of one percent. While the market is open, the index is recalculated every 15 seconds.

Russell changes the components of its index as little as possible. It removes a stock from the index only when it no longer qualifies as a small growth stock. For example, the company may have become too big, or the stock's price-earnings ratio may have gotten too low to count as a growth stock.

Along comes an index fund, which endeavors to track the Russell Index of small U.S. growth stocks. Unlike Russell, the fund actually buys and holds the stocks Russell counts in its index. When Russell removes a stock and replaces it with another, the fund follows along, selling the stock Russell removed and buying the replacement.

Since Russell changes the components infrequently, the index fund buys and sells infrequently. As a result, while you hold shares of the index fund, you're unlikely to incur big capital gains taxes. You may pay capital gains when you sell your shares of the fund, just as your neighbor did above. But while you hold the fund, the capital gains allocated to you are usually modest.

Drop your yearend reluctance. There are always reasons not to buy stocks. Disregard them all. The best time to buy stocks is when you get the money. The best time to hold them is forever.