You can expect a record number of mutual-fund closures for 2008, as many management companies are looking at thinning their herds of underperformers. So investors need to figure out what to do when that happens.

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Just in time for the holiday season, my wife received a notice that the fund she uses for her Roth IRA will shut its doors on Dec. 8.

The fund itself had been a middle-of-the-pack performer, and we certainly would have expected a bounce-back along with any rebound in the market.

But the board of directors felt the fund (and one of its two sisters) was too small to be operated economically; it was one of two responsible decisions made by the board, the second being that they decided to liquidate the fund, rather than folding all accounts into the surviving sister, which has a slightly different investment objective.

Better to give investors their remaining dollars back than invest their money in a fund in an entirely different asset class.

The fund is hardly alone — in fact, you can expect a record number of fund closures for 2008 — as many management companies are looking at thinning their herds of underperformers, issues that failed to attract a following and that have now shrunk down to where management is questioning whether they can swallow operating costs and come out the other side of the current downturn with a fund worth keeping. (In an upcoming column, I will take a look back at some of the funds that perished in 2008.)

That said, my wife was a bit flummoxed by the unexpected move, having never faced a shutdown and recognizing that she needed to act quickly to avoid a potential tax nightmare.

Mutual funds vaporize unnoticed every day, most being folded into something bigger, some simply closing up shop. In some cases, management asks for shareholders to approve a liquidation or merger in a proxy vote, but typically the fund firm doesn’t need your approval to shut down; in either case, fund investors really shouldn’t want to stick around in a fund where management has thrown in the towel.

The escalation in fund closures is a pure combination of mathematics and economics. If a fund has $5 million to manage and has an expense ratio of 2 percent, the management company is bringing in a total of $100,000 to pay the salary of the manager, the staff and to cover other costs.

For a money manager with a lot of other assets to worry about, a small fund is hardly worth it; any fund with less than $50 million in assets isn’t particularly attractive to other fund companies to buy, so dismal investment returns and increased shareholder redemptions have pushed a lot of funds into the territory where the board is likely to consider a mercy killing.

For investors, the possibility that a fund might fail and liquidate is not a reason to go elsewhere — especially if you believe a tiny or new fund has big-time potential — but the actual shutdown of a fund is an annoyance.

When a fund liquidates, it sells all holdings and gives shareholders the full market value of their holdings. If you hold the fund in a taxable account, unloading the shares — whether you do it before the fund dies or simply wait to get a check — can trigger a tax bill on any gains or can capture tax benefits from long-term losses. In some cases, this can happen when the assets of a small fund are rolled into a similar sister offering.

In addition, investors who have a liquidating fund in an individual retirement account have other concerns; typically, if they hold the fund on the day it closes for good, the fund’s transfer agent will send them the proceeds of their account, but will automatically take a 10 percent federal tax withholding, because it considers the payout a “distribution.”

An investor who is eligible to roll the account over or transfer the proceeds directly into another IRA (as my wife is doing) can only avoid the tax withholdings by acting before the fund liquidates.

In general, it takes about six weeks for a fund to go from board vote to actual shutdown, and shareholders tend to be notified within 14 days of the decision to close; that leaves investors with a month to act, which gets dicey for those investors who assume every mailing they get is boilerplate and who open letters from a fund once every six months or so.

Retirement savers can complete some tax paperwork to withdraw the funds without the distribution, but will have 60 days from receiving the money to complete the transaction or face Internal Revenue Service penalties.

If one of your funds is next to give up the ghost, quickly pick a landing pad for the money, determine the tax implications of any transaction and call the fund’s transfer agent to see how to handle the change most effectively.

Get it done and move on, or you could mourn the loss of your fund — specifically what it cost you in taxes or depleted retirement assets — for years.

Chuck Jaffe is a senior columnist at MarketWatch columnist. He can be reached at or Box 70, Cohasset, MA 02025-0070.