Capital gains season approaches for mutual fund investors. Once again, it will be a good news/bad news period. Most actively managed stock funds have enjoyed strong absolute gains in 2021, but that means many of them estimate that their year-end distributions to fundholders will range in 9-23% The taxes owed on those payouts could be the worm in the apple of an otherwise great year for investors who hold their funds in taxable accounts.

Funds must pass those long- and short-term gains on to shareholders who, if they own their funds taxable accounts, must pay Uncle Sam. Fund companies have begun publishing distribution estimates on their websites, and most will actually make the payouts in early to mid-December.

What Is A Mutual Fund Capital Gain If I Haven’t Sold?

By law, funds are required to distribute their net capital gains that they realize by the end of October each year. So, they have to distribute income, but they also have to distribute all the capital gains they realize. And that doesn't relate to what kind of profits or losses you might have made in the fund. It's sort of independent. After you sell the fund, then that all totals out. But in the meantime, they distribute every year that they realize net gains.

If you do own a mutual fund in a taxable account, and you find out that it is going to make a distribution, you're going to pay taxes on that distribution even if you continue to own the fund.

Why Does This Happen?

There can be a host of reasons and the biggest problem is that they can be unpredictable

1. Market Action: When stocks are up strongly, a value fund manager may sell securities that have appreciated to a point that management no longer believes them to be attractively valued. This can result in higher distributions to shareholders at year end.

2. Investor Behavior: On the other hand when the fund is performing poorly or the market is plummeting, investors start selling their shares. This forces management to sell positions to meet the redemptions of the investors who sold. Also trend of investors swapping out traditional active mutual funds for exchange-traded funds has led many managers to realize gains to rebalance their portfolios and meet redemptions (giving money back).

3. Management Changes: If a fund’s manager or subadvisor changes, new management may decide to reshuffle a fund’s portfolio, realizing gains and potentially driving up the fund’s distributions. In 2018, Class 3 Harbor International (HIINX) distributed nearly 40% of its net asset value after a new subadvisor came on board.

4. Fund Closures: When fund close to new investors, they limit the amount of new money coming into the fund to purchase investments and also are more affected by redemptions by current investors due to the limited number

5. Embedded Gains: A fund that hasn't made large distributions in recent years may simply have large “embedded” capital gains—meaning gains that haven’t been realized yet—or it may have offset its gains with losses. Like individual investors, funds can use realized losses to offset gains, and losses can be carried over into future years. After the 2008 bear market, some funds had so many losses on the books that they didn’t make capital gains distributions for years. At the time, these funds may have looked extremely tax efficient, but once they’d used up their losses, the funds started distributing capital gains again.

Funds must pass those long- and short-term gains on to shareholders (You) who, if they own their funds taxable accounts, must pay Uncle Sam. Fund companies have begun publishing distribution estimates on their websites, and most will actually make the payouts in early to mid-December.

Does It Matter For Everyone?

First, let's review why these distribution previews matter. If you invest in a tax-sheltered account, such as a 401(k) or an IRA, and you're reinvesting your distributions, this is a nonevent. You'll owe taxes only when you begin selling your holdings in retirement. Qualified withdrawals from Roth IRAs aren't taxed at all.

If you hold a fund in a taxable account, however, you'll owe taxes on the distributed gains, even if you reinvested them, unless you've sold losing positions to offset the gains.

Taxable investors considering buying a fund that has predicted it will make a distribution also may consider delaying the purchase until after the payout to avoid getting distributions without the benefit of any of the gains.

Tax considerations, of course, are just one of many factors in an investment decision.

An Example:

Neutral-rated American Century Equity Growth (BEQGX) plans to pay a 23% distribution on Dec. 21 owing to turnover triggered by process and personnel changes. It has a tax-cost ratio of 2.85% over the last 3 years, which means you as an investor are losing 2.85% off your return due to tax efficiency (or lack there of).

Let's compare that to the Vanguard 500 Index Admiral Fund (VFIAX). The Vanguard fund also has a relatively high Potential Capital Gains Exposure ratio at 42%. But this exposure is never likely to be realized, as the Vanguard fund has exceptionally low turnover. The tax-cost ratio is a miniscule 0.43%.

What Should I Do?

Probably just prepare to pay. Only if it's something really extreme would you consider selling, such as you bought the fund in June and now it's going to make a 30% capital gains distribution, which is pretty rare. Otherwise, you really just have to prepare to pay taxes and avoid the fund for those two months if it's going to be at all a meaningful gain, then you can buy after it's made that payout.

But in reality you should do a deeper dive into why this is happening

1. You should find out which funds and how much they are paying.

2. Determine if those funds are part of your long-term strategy and financial plan as outlined in your IPS (Investment Policy Statement).

3. Is there a way to hold these funds in a tax-deferred account (401k, IRA, etc) where you can avoid this in the future?

4. Is there a different investment that achieves the same goals without the annual tax headaches?

Future Considerations

Given that active mutual funds are more likely to make capital gains distributions than a passive fund or an ETF, there a case to be made that really if you want to have active strategies, it might be best to sort of tuck those in your tax-deferred accounts.

And if you have taxable accounts, maybe stick more with index funds, ETFs, and individual stocks, which tend to be a little bit more tax-efficient from a distribution standpoint.

Conclusion

The takeaway here is that there are no shortcuts to help you determine which funds will make year-end distributions. Every year is different. So, if you own funds in a taxable account, make sure you’re paying attention at year end and setting aside extra time to keep up with distribution estimates and decide what action to take if a fund you own expects to make a big payout. 

If you need help managing the tax consequences of your investments, click here to set up a time to talk. There are often many opportunities to make tax-efficient moves in the last months of the year.

About the Author

Erik Barnes, CFP®, is a fee-only financial advisor serving clients locally in Naperville, IL, and the surrounding Chicagoland area and throughout the U.S. He is a member of XY Planning Network, a group of fee-only financial advisors who focus on serving those in Gen X and Gen Y, as well as NAPFA, Fee-Only Network, and the Financial Planning Association. Erik has worked in financial planning for 20 years and takes great pride in helping clients on the road to retirement. When he’s not building financial plans, you can find Erik tinkering with his fantasy football roster or checking out one of the many food spots in Chicagoland.

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