Capital Gains Distributions. Those three words can turn seasoned mutual fund investors’ stomachs, specifically those with taxable accounts. This is the time of year where you may receive an unwanted surprise: long or short term capital gains from your funds. This year will be no different. In fact, as mutual fund companies begin to provide their estimated capital gains distributions, the expectation is that the 2021 capital gains season will be one of the highest on record. According to Investment News, “…more than 110 funds are already showing capital gains distributions of more than 20%1.” What does this mean for you, the investor, and what can you do about it? We will touch on that- but first, let’s discuss what a mutual fund is, why they distribute capital gains to shareholders, and why they could still be an appealing investment vehicle even considering the tax consequences.
Mutual funds, in their simplest form, are a basket of securities generally invested based on an investment style (i.e. US Large Cap Growth, International Equity, etc.). Throughout the year, the professional money managers that are tasked with managing the fund will make decisions on which securities they want to buy or sell. It is this professional management and diversification of investments within mutual funds that appeals to investors; however, as these purchases and sales accumulate, so too do the realized gains and losses within the mutual fund. Here is where capital gains distributions come into play. Mutual funds are unique with regard to IRS mandates concerning taxation and distributions. When a mutual fund sells securities that have appreciated in value and the fund doesn't have any offsetting capital losses, it must distribute those gains, along with dividends or interest, to shareholders. Shareholders, in turn, are required to pay taxes on the gains2. Theoretically, if a mutual fund is paying out a capital gains distribution it should be a reason to celebrate, since one or more investments within the portfolio have appreciated in value to the point where the manager no longer sees value in that security or no longer wants to maintain the current position size. But that isn’t always the case when the tax bill comes due. One final point that should not be overlooked, if you hold a mutual fund in a tax-deferred account (IRA, 401k, 403b, etc.), you won’t need to pay taxes on the capital gains distribution, as these are deferred until assets leave the account; realized gains only affect investors who own mutual funds in a taxable account.
So now that you have a better understanding of how mutual funds operate and their IRS mandate, let’s talk about potential strategies to manage your tax liability. Option 1 is simply to not own mutual funds within taxable accounts. This strategy speaks to the heart of asset location. The upside to this strategy is that you won’t have to worry about surprise capital gains distributions, and you are in control of when you want to realize any capital gains on your investments. The downside to this strategy, as noted above, is that mutual funds provide diversification and active management, which are important to investment portfolios. Option 2 is to sell the fund prior to its capital gains distribution. This may not be a viable solution if you have a large amount of unrealized capital gains, but it could make sense if you currently have an unrealized loss in the position.
Option 3 is to take your capital gains distributions in cash rather than reinvesting, using the cash to pay the capital gains tax. A final alternative is to select a different investment vehicle for your taxable accounts; examples include exchange traded funds (ETFs), separately managed accounts (SMAs), or individual securities (stocks/bonds). With these investments you have more control over your gains.
In summary, mutual fund capital gains distributions are a result of portfolio managers realizing gains in positions within the fund and distributing them to shareholders. As mentioned, there are potential strategies that can be used to mitigate the effect on your income taxes and we certainly welcome the opportunity to discuss further. In the meantime, brace yourself for an above average capital gains distributions season, with the understanding that investment gains are a good problem!