With the market declines that we’ve experienced in recent years, there’s been a silver lining. Mutual funds haven’t been distributing much in the way of capital gains. That may soon be coming to an end, however. Even though we’ve lost much of the gains from earlier this year, the market has advanced quite nicely from its low point in March 2009. At the time of writing, in spite of the recent market gyrations, nearly all asset classes are up for the year.

In a recent article in the Wall Street Journal titled “Tax Bomb Threatens Funds” (Saturday, May 15, 2010), author Eleanor Laise warns that funds may be distributing significantly more taxable dividends and capital gains this year than last. This, of course depends to some extent on what happens in the market for the rest of the year.

Ms. Laise article noted: “Many funds that looked benign from a tax perspective a year ago or so now look less friendly. Fidelity Dividend Growth Fund’s potential capital gains exposure in late 2008 was -73%”. She went on to say: “After a 51% return in 2009 the fund’s potential capital gains exposure has flipped into the black, with 1.9% of assets representing gains not yet distributed to shareholders.”

Only time will tell whether the average fund will distribute capital gains this year. Regardless, it makes sense to plan for such a possibility. You can avoid tax penalties if you have enough being withheld from your paycheck or make large enough estimated tax payments.

The IRS rules state that, generally, you won’t owe a penalty for 2010 if any of the following apply:

(1) The total of your withholding and timely estimated tax payments equals or exceeds your total 2009 income tax due. If your Adjusted Gross Income exceeded $150,000 in 2009, then your withholding and estimated payments for 2010 must equal or exceed 110% of your total 2009 income tax.
(2) The tax balance due on your 2010 return is less than 10% of your 2010 tax and you paid all of your estimated payments, if any, on time.
(3) Your total 2010 tax, less withholding is less than $1,000.
(4) You had no tax liability for 2009.

We’ll have to wait to find out what the mutual fund distributions will be this year. We usually call our mutual fund companies or check their web sites for expected capital gains distributions in late November or early December, to avoid any surprises. The bottom line is that a little bit of tax planning can often save you from an unexpected tax penalty.