This year my uncle discovered that he had to pay capital gains tax on a mutual fund he owned, even though he had not sold the fund. Moreover, the fund had decreased in value during the year. What happened?
Capital gains distributions may occur when a fund’s manager sells shares of securities held within the fund. These distributions may be taxable and can be an unpleasant surprise for investors with taxable accounts (as my uncle found out).
Each year, usually in November or December, mutual fund shareholders face the possibility of receiving capital gains distributions from their mutual funds. These capital gains distributions result from management selling shares of one or more of the fund’s holdings during the taxable year. A manager may decide to sell because of a changing outlook for a security, to raise cash for shareholder redemptions or merely to rebalance the fund. If the security is trading higher than when the fund manager purchased it, the fund must pass along the gains and resulting taxation to the shareholder.1
If the mutual fund is held in a taxable account (as opposed to an IRA, for example), the capital gains distribution is taxable to the fund shareholder. Moreover, the tax occurs even if the shareholder purchased the fund after the manager realized the gain in the year it occurred. For example, a shareholder who purchases XYZ fund in October may end up paying a capital gain tax at the end of the year, even though the fund manager sold the shares of security ABC in July! For this reason, investors may want to avoid the purchase of certain mutual funds in a taxable account later in the taxable year.
What can you do to protect yourself? You can usually find out about any scheduled distribution on a fund’s website in November or December. There are also websites that provide payout information for multiple funds or fund families.2 Armed with this information, you can determine if it makes sense to sell the fund before the distribution, and possibly repurchase the fund later. However, other factors must be considered in this determination, particularly the capital gains impact if your selling price of the fund is higher than your purchase price.
You may also scout your portfolio for offsetting losses. Perhaps there are stocks or funds you want to sell anyway or can swap into similar investments after booking a loss, and then using this loss to offset the capital gain from the mutual fund distribution. You might also opt for more “tax efficient funds” with lower security turnover rates and decide to hold less tax efficient funds in a tax deferred account where annual gain distributions could be less problematic. Finally, some other assets such as municipal bond funds, index funds and ETFs may be good choices for taxable accounts.3
At the Family Wealth Decisions Group, we pay particular attention to the mutual fund tax trap, and using the above strategies as well as others, we help our clients prepare for and address these capital gains distributions in the context of their overall plan.
If you would like to know more about mutual funds capital gains distributions, please feel free to contact us. Remember, we are here to help.
Doug Lemons
1https://www.thebalance.com/mutual-fund-capital-gains-distributions-2466692
2https://mutualfundobserver.com/discuss/discussion/52943/2019-capital-gains-distribution-estimates
3https://www.morningstar.com/articles/720873/what-you-need-to-know-about-capital-gains-distributions
This material is for general use with the public and is designed for informational or educational purposes only. It is not intended as investment advice and is not a recommendation for your retirement savings. Lincoln Financial Advisors does not offer legal or tax advice.
Registered Associates of Family Wealth Decisions Group are registered representatives of Lincoln Financial Advisors Corp. Securities and investment advisory services offered through Lincoln Financial Advisors Corp., a broker/dealer (member SIPC) and registered investment advisor. Insurance offered through Lincoln affiliates and other fine companies. Family Wealth Decisions Group is not an affiliate of Lincoln Financial Advisors Corp. CRN-2886008-123019