The excessive distribution method


Under this method, you do not report any income until you either receive a distribution or sell the shares. When this happens, your earnings are taxed at the highest ordinary income rate (39.6% as of 2013), regardless of your actual income tax bracket. You must also allocate your gains "ratably" over your investment period. Then you are hit with an interest charge, compounded annually, starting on the first day you invested.

Here’s an example:

Suppose you invest $10,000 in a foreign fund. After 5 years, you sell the fund for $15,000. The IRS assumes your gain was earned equally over the 5 years, so you need to allocate $1,000 to each year. For the first year your tax is 39.6%, or $396 (regardless of your actual tax bracket). Then you need to pay interest (assume 8%) over the last 5 years. This is repeated for each of the following years. This method generally results in significant payments due to the accrued interest (compounded). And losses are not tax deductible.