Investors are likely to receive a capital gains tax bill this year.
Despite the market drop earlier this year, many equity mutual funds have positive returns so far this year — so investors are likely to receive mutual fund capital gains distributions along with a capital gains tax bill reflecting their profits. Capital gains can result from rising share values and they can come from mutual fund dividends, which are profits companies share with stockholders. Mutual fund distributions are derived from net capital and can affect your tax cost. Tax laws require mutual fund companies to distribute net capital gains by the end of the year, usually based on gains realized through September or October. Here are nine facts to know about capital gains when it comes to mutual fund investing.
Heavy fund outflows may trigger distribution.
Heavy fund outflows trigger capital gains distributions because of how mutual funds are structured. Mutual fund investors have all their money together in the fund, says Todd Rosenbluth, director of exchange-traded fund and mutual fund research at CFRA. When some of those investors want their money back, the fund company must return cash to shareholders. If the mutual fund owns stocks and is close to being fully invested, the fund may need to sell shares of those stocks to meet those redemptions. There can be a capital gains taxable event if the fund sells winning positions, which is then passed along to all the remaining shareholders, he says.
Mutual fund capital gains have been strong in recent years.
Many mutual funds rebounded after the March sell-off, and that, combined with the unrealized gains built up over the past 10 years of bull markets and the equity outflows caused by investors moving to ETFs from mutual funds, could mean a tax bill for mutual fund holders this year. “From that perspective, we could see larger-than-usual capital gains distributions this year,” says Amy Arnott, portfolio strategist for Morningstar. How much will depend on the fund and whether the manager was able to sell holdings that had unrealized losses to meet those redemptions out of the fund.
Investors can research possible capital gains exposure.
Mutual funds must include information in their annual report about potential capital gains exposure, Arnott says, and it can give investors a good sense of possible distributions. She says certain funds had high capital gains exposure at the end 2019, such as the Fidelity Blue Chip Growth Fund (ticker: FBGRX), which was relatively high at 76.7%. “If you are thinking about buying an equity fund for a taxable account, you may want to check that number before you do that,” she says. Funds that have had large potential capital gains and have experienced outflows usually have a much higher potential for capital gains distributions. Some funds are likely to have sizable distributions this year — including several from JPMorgan Chase & Co. (JPM), such as the JPMorgan U.S. Large Cap Core Plus Fund (JLCAX), which will see a distribution of 21% of net asset value.
High turnover rates may lead to more capital gains.
Since mutual funds are required to distribute their gains, a fund with high turnover is more likely to create capital gains, says Kevin Dorwin, CEO at wealth management firm Bingham, Osborn & Scarborough. Turnover rates measure how often a fund buys or sells during a year, and that can increase your tax bill, reducing your return because distributions are taxable. “The transactions that create turnover are a hit against returns because there’s a cost (to) those transactions,” he says. Dorwin says investors can protect themselves from excessively high capital gains exposure by choosing funds that have lower turnover rates, and most financial websites list those statistics. Actively managed funds have a higher turnover, whereas index funds and ETFs have a lower turnover.
Fund manager changes may trigger sales.
When a portfolio manager leaves a fund, it can mean a change in strategy. The new fund portfolio manager may sell many of the holdings, triggering capital gains. That’s an issue for both current and new fundholders and something to monitor. “If there’s a change in management, and even if the fund company says there’s not going to be major changes, sometimes the new manager does end up cleaning house in the portfolio and wants to put their own stamp on things,” Arnott says. She notes that in 2018, Artisan International Small-Mid Fund (ARTJX) changed managers and made a sizable capital gains distribution of more than $8 per share.
Not all capital gains are created equally.
Short-term capital gains occur when an investment is held for less than one year, says Matt Berquist, managing director at Intrepid Capital. Long-term capital gains happen when a portfolio manager sells a stock that the fund has held for a year or longer. That matters because short-term and long-term capital gains are taxed differently. Short-term capital gains are taxed at the mutual fund owner’s ordinary income tax rates, which can be as high as 37% for the top tax bracket. Long-term capital gains are taxed at either zero, 15% or a maximum rate of 20%. “That’s why it really benefits to hold things for the long term,” he says.
Capital gains taxes can occur in down market years.
It’s rare, but sometimes mutual fund owners pay taxes on capital gains distributions even if the fund lost money by year’s end. This year value funds likely lost money, Rosenbluth notes, and holders of those funds may still have to pay capital gains. “Capital gains are based on how long the stock has been in the portfolio and how it has performed in the portfolio,” he says, noting that positions held for multiple years are likely up, even if the fund lost money this year.
Keep high-turnover mutual funds in tax-sheltered accounts.
Rosenbluth says the main way to avoid the tax impact triggered by an actively managed mutual fund’s capital gains distribution is to hold the fund in a tax-advantaged account, such as a 401(k) or a traditional individual retirement account. That’s particularly important for funds with high turnover rates. However, he says, this is only a temporary solution as mutual fund owners will eventually have to pay the taxes when they take distributions from those tax-sheltered accounts. Another alternative is to use ETFs instead, as those vehicles are structured to be tax-efficient, he says. ETFs deal with redemptions by passing along stock to authorized participants, the middlemen involved in the ETF itself, rather than to other fundholders — so there is no taxable event for the average person.
Don’t buy mutual funds near the end of the year.
Be cognizant of the calendar when buying mutual funds, Berquist says, especially at this time of year. Investors who buy a mutual fund before capital gains and taxes are issued to shareholders could be stuck with a tax bill. To avoid this, read the mutual fund company’s website, which provides distribution information. “If you know the fund is going to distribute 3% of its net asset value as a gain, in most circumstances you’re going to want to wait until after it’s been paid to invest,” he says. That could mean holding off until late December or January.
Nine facts about mutual fund capital gains distributions:
— Heavy fund outflows may trigger distribution.
— Mutual fund capital gains have been strong in recent years.
— Investors can research possible capital gain exposure.
— High turnover rates may lead to more capital gains.
— Fund manager changes may trigger sales.
— Not all capital gains are created equally.
— Capital gains taxes can occur in down market years.
— Keep high-turnover mutual funds in tax-sheltered accounts.
— Don’t buy mutual funds near the end of the year.
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Update 11/25/20: This story was published at an earlier date and has been updated with new information.