To buy or not to buy? That is the question often posed by mutual fund

investors in December, fearful of buying funds in a non-registered account and

then being forced to prepay tax on "someone else's gains."

As a result, the conventional wisdom often posited in investor-oriented

financial newsletters and Web sites is, don't buy mutual funds in December -- or

at least don't buy before the fund's distribution date.

Before heeding their advice, let's take a closer look at the mathematics of

distributions to try and quantify the actual cost of this tax prepayment.

Say on Monday morning you buy 1,000 units of a fund that costs $10 and has an

estimated 2005 capital gains distribution of 5%, or 50 cents per unit, on

December 20 (each fund's distribution date will differ).

If you're in a 40% tax bracket, and since only one-half of capital gains are

taxable, you'd pay $100 of tax on the $500 capital gains distribution when you

file your 2005 tax return next spring (50 cents x 1,000 units x 50% x 40%).

On December 21, the day after the distribution, the fund's price will drop by

50 cents, to $9.50, assuming no additional market fluctuation. If you

immediately sell that fund, you'd realize a capital loss of $500 ($9,500 less

cost of $10,000). That loss could then be used to offset the capital gain

realized. So the $100 in tax isn't a true cost, but one that can be recovered

through a sale of the fund.

To make this point even clearer, let's compare a purchase before and after a

distribution.

Let's say Jack buys $10,000 in units on December 12, receives the capital

gains distribution of $500 (which we'll assume he took in cash, so we can

compare the same purchase post-distribution) and pays the $100 of tax in 2005.

His adjusted cost base (ACB) or tax cost is the $10,000 he paid. Jack's net

investment in the fund is $9,500 (the $10,000 invested, less the $500

distribution received in cash).

Let's assume that a year later, the fund has increased in value from $9.50 to

$10, and Jack sells all his units. The proceeds will be $10,000 (1,000 units x

$10/unit). If he deducts the ACB of $10,000, Jack won't pay any tax in 2006 on

this capital gain.

Now let's compare Jack to Jill, who buys on December 21 -- the day after the

distribution, when the unit price has fallen to $9.50. If she invests the same

amount of money -- $9,500 (her ACB) -- and also sells a year later, when the

fund price rises back up to $10/unit, she'll realize a capital gain in 2006 of

$500. That means she'll pay $100 of tax in 2006.

Since Jack bought the fund before the distribution, he has essentially

prepaid $100 of tax that wouldn't have been due until he sold the fund.

In both cases, the investor pays the same amount of tax -- $100. If you buy

the mutual fund before the distribution, you pay tax on the distribution in the

2005 tax year. If, however, you buy the mutual fund after the distribution, the

tax is postponed until the year of the ultimate sale of the units.

So the real price of purchasing a fund before a capital gains distribution is

the opportunity cost of not having the $100 tax prepayment invested and working

for you. What's this actually worth? Assuming the $100 tax prepayment was

reinvested back into the fund and earned, say, a 6% capital gains return, taxed

at a 20% capital gains tax rate, the opportunity cost after one year would be

about $5 ($100 x 6% x (1 - 20%)) -- or the cost of a grande eggnog latte.

Even going out five years, which is beyond the average holding period for a

fund in Canada, the after-tax opportunity cost of prepaying the $100 tax is

about $27 -- and that's on a $10,000 investment.

By deferring your investment decision until after the distribution, you may

be missing out on the market movement while not invested. If the fund in

question went up even 50 basis points during that period, you'd have more than

made up for the $27 of tax payable on that $500 distribution.

Some food for thought this December...

GRAPHIC: Table: HOW YOUR MONEY WORKS FOR YOU: Tax payable on a purchase before

or after a distribution.: (See print copy for complete table.)