Consider yourself warned: Before making a large mutual fund investment this late in the year see if you would inherit a tax bill from a year-end capital gains distribution. You might avoid it by waiting.
It’s standard advice to fund investors using taxable accounts. But conditions change and sometimes the danger is worse than others. So what’s worth noting this year?
Mainly that stocks have been on the rise for so long that big distributions may be unavoidable for some funds. Fund managers who want to soften the blow by harvesting losses don’t have many losing investments to sell, and many managers don’t even try because most their shareholders use individual retirement accounts, 401(k)s and other tax-favored accounts and therefore don’t pay this annual tax.
“With the continuance of the bull market many domestic equity funds have a sizable amount of embedded gains, which when distributed, can cause significant taxable issues for investors” holding shares in taxable accounts, says Paul Z. Shelton Jr., principal at Warwick Shore Advisors in Orlando, Florida.
“It is likely with the last couple years being good years that distributions will be bigger” than usual this year, adds Julia Carlson, founder of Financial Freedom Wealth Management Group in Newport, Oregon.
Year-end distributions are a common feature among actively managed mutual funds. Federal law requires that funds pay shareholders the net gains on assets the fund managers sold during the year. If the fund is held in a taxable account rather than an IRA or 401(k), the distribution is taxed as a capital gain, even if the payment is reinvested in the fund.
Purchasing a fund prone to big distribution late in the year means inheriting this tax bill for no good reason. That’s because the cash from sales during the year is reflected in the share price when the fund is purchased. All else being equal, the share price will drop when the distribution is paid because that cash is no longer included in the fund’s assets.
If you paid $10 for a share that paid out $1, you’d end up with a $9 share and $1 in cash. You would be no wealthier but would be taxed on the $1. But if you bought after the distribution, you would pay $9 a share and end up with more shares and no tax bill.
Of course, by waiting you’d risk missing out on any gains in the meantime, so experts suggest several things to consider in deciding what to do.
Most important is to realize that the risk varies from fund to fund and year to year. Actively managed funds are more likely than index funds to have big payouts, because all that management involves a lot of buying and selling. Index funds, on the other hand, just buy the securities in an underling index like the S&P 500 and hold on to them.
Fund companies typically list estimated distributions on their websites in October or November and make payments in December.
Funds with lots of turnover can also have big distributions. Shareholder redemptions force the fund to sell assets to raise cash, and distributions result if the sales produce net gains.
“Watch out for funds that have dramatically plummeted in value and are forced to sell highly appreciated holdings to meet shareholder redemptions,” says David M. Tobin, founder of Tobin Investment Planning in Voorhees, New Jersey.
“Another red flag is stock funds that are sitting on large unrealized gains while experiencing heavy investor outflows. In both cases all shareholders must then share the burden of paying taxes on those realized gains, even if the fund value itself has declined.”
Other things to consider:
Index alternatives. As mentioned, index funds and exchange-traded funds tend to have lower distributions, so an investor hit with big payments in a managed fund can look for a less hazardous alternative.
Tax-managed funds. Some funds are deliberately managed to minimize tax bills. The fund might look for losers to sell to offset the gains from winners, reducing the net gain to be paid out.
“Broad stock market exchange-traded funds, traditional index funds, and tax-managed funds all tend to be more tax-efficient than actively managed products,” says Gary DuBoff, principal in the Tax and Accounting Department at MBAF, an accounting and advisory firm in New York City.
Tax-favored accounts. An investor who finds a big-paying fund irresistible can buy it in a tax-favored account like an IRA or 401(k), so the distribution will not be taxable.
Shelton notes that the income tax cut that took effect this year can make it cheaper to switch out of profitable investments for ones likely to have smaller distributions. Carlson says that under the new rules singles reporting income of $38,700 or less and couples reporting up to $77,400 pay zero percent on long-term capital gains, making it easier to switch out of funds that could cause headaches in the future.
Keep perspective. Although distributions can cause an unwelcome expense, experts generally say the tax tail should not be allowed to wag the investing dog. If the fund has great prospects in the near term, it may be better to buy and pay the tax than to wait and miss the gains.
Roger Young, senior financial planner at T. Rowe Price in Owings Mills, Maryland, also says that investors are not taxed twice. If you reinvest a distribution, it is added to the cost basis of that holding, which reduces the gain you’ll report after selling shares in the future.
Harvest other losses. Distribution income can be offset by taking losses on other investments before the end of the year. If fund A has a big payout but fund B has lost money, you can sell some or all of B to book the loss and subtract it from the gains reported for A.
“I suggest adding a separate tax-loss harvesting strategy to your portfolio,” Shelton says, adding that losses can be realized on volatile investments throughout the year, not just at year-end.
Of course, no one likes losses and it would not pay to deliberately seek money-losing investments just to offset gains. But selling a loser earlier in the year gives you time to buy it back and enjoy a rebound without running afoul of the wash-sale rule. That says you cannot claim the loss if you buy the same security within 30 days of selling it.
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