Nobody likes a surprises in their taxes, especially when it comes to their investments.
Unfortunately, many investors don’t realize some investments distribute capital gains every year. Mutual funds are required to distribute substantially all net investment income to shareholders, and that can mean receiving unexpected capital gain distributions towards the end of each tax year.
If you hold mutual funds in a nontaxable account like an IRA or 401(k), this is no big deal. But for investors in regular brokerage accounts or trusts, these mutual funds can lead to a big tax bite in the form of capital gains taxes.
What are capital gain distributions?
Most investors already know that mutual funds buy and sell securities, like stocks and bonds, throughout the year. What many investors may not realize is that if the mutual fund incurs a capital gain (selling something for more than they bought it for), they have to distribute those gains out to their investors before the end of the year.
Even if mutual funds aren’t performing well, they can still have big capital gain distributions if they’re forced to sell their underlying holdings. This is one of the worst situations a fund can find itself in. If investors are demanding redemptions while the underlying holdings are falling in value, a mutual fund can be forced to sell highly appreciated assets as investors cash out. Insult, meet injury.
2016 mutual fund capital gains
Some of the biggest offenders we saw last year were the Morgan Stanley Mid Cap Growth Fund (MPEGX) and the Delaware SMID Cap Growth Fund (DFCIX), both of which performed negatively for the year but distributed well over 20 percent of their net asset value in capital gains.
Even some well-known names like the Columbia Acorn Fund (ACRNX) and a couple of Vanguard funds (VSBMX and VSLIX) distributed over 20 percent in capital gains last year.
To illustrate how these capital gains taxes work, let’s say you have a $10,000 investment in one of these funds and the fund distributes over 20% of its net asset value in a capital gains distribution. That means you may have to pay taxes at your capital gains tax rate on a surprise distribution of over $2,000. Always speak with a qualified CPA to understand your specific tax situation.
Strategies for capital gain distributions
Some investors attempt to avoid these capital gains by redeeming their interest in the fund and swapping into something else before the distribution date. A word of caution: while that approach can be effective, it’s worth noting that you may end up paying more in capital gains by selling the fund in advance than if you simply held it. Plus, you could lose money by sitting out of the market or investing in something else. On the other hand, if you have an unrealized loss in an investment, you may be better off from a tax standpoint by selling the investment and harvesting that loss.
Know if you hold mutual funds in a taxable account, it’s worth checking the fund’s website towards the end of the year through a quick Google search, or check a site like capgainsvalet.com to be aware of the distribution. You may want to earmark funds to cover the tax bill.
One strategy to earmark funds is to simply tell your financial adviser not to reinvest the proceeds from the distribution, and hold the amount in cash or money market instruments until tax time. Now may be a good time to review last year’s distributions to get a sense of what your tax liability may be next year.