Investors are likely to receive mutual fund capital gains distributions, along with a capital gains tax bill reflecting their profits – especially because of sizable gains in the S&P 500 (.SPX) this year. Capital gains can result because of 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.
Mutual fund capital gains have been strong in recent years
Christine Benz, director of personal finance at Morningstar, says two reasons are behind the trend of higher mutual fund capital gains distributions in the past several years – a long-running equity bull market combined with redemptions in an actively managed mutual fund. She says actively managed mutual funds are seeing big redemptions because many investors are moving to indexed mutual funds and exchange-traded funds, which have much lower costs than active funds. "That trend very much persists into this year. We continue to see very big outflows from active funds," she says.
Heavy fund outflows may trigger distribution
Heavy 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 ETF 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.
High turnover rates may distribute 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, managing principal at wealth management firm Bingham, Osborn & Scarborough. Turnover rates measure how often a fund buys or sells during a year, and that cost comes from the fund's assets. 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. He says, generally, growth funds have higher turnover rates than value funds.
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. Benz says that's what's occurring now for holders of Invesco funds. When Invesco acquired OppenheimerFunds this year, many fund managers were replaced and the new managers are changing strategies. Two Invesco funds that are expected to see big payouts are Invesco Oppenheimer Capital Appreciation Fund (OPTFX) and Invesco Mid Cap Growth Fund (VGRAX), with payouts equal to 21% and 20% of their net asset value, respectively. Both saw manager changes this year, which likely caused selling of some long-held positions, she says.
Not all capital gains are created equally
Short-term capital gains occur when an investment is held for less than one year. Long-term capital gains happen when a portfolio manager sells a stock 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. Long-term capital gains are taxed at either zero, 15% or a maximum rate of 20%. How much mutual fund owners pay for long-term capital gains tax also depends on their income, says David Reyes, founder of Reyes Financial Architecture.
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, Reyes says. Mutual funds usually base their yearly gains in September or October, with those net capital gains, and taxes, distributed by December. If a fund's value falls at the end of the year, owners still need to pay the taxes from gains made earlier. Reyes says this happened during the 2008 financial crisis as mutual funds saw sharp gains earlier in the year. But by December prices fell sharply and mutual funds had to sell holdings to give money to investors who asked for redemptions. "Investors lost money and they had to pay taxes. It's a quirky issue that added insult to injury," he says. The fourth-quarter market sell-off in 2018 created a similar situation.
Capital gains distributions increase the cost basis
Paying capital gains taxes now can limit taxes paid in the future, Benz says. When investors receive capital-gains distributions from a mutual fund, they pay taxes on that amount, in the year the distribution occurred. Investors who reinvest the distribution raise their cost basis, which is the value of an asset for tax purposes. "The goal of the accounting is that you're not going to have to pay taxes twice. It accelerates your tax realization," she says. Lifting the cost basis lowers the taxable amount investors must pay between the purchase price and the price they receive when selling the fund. Mutual fund companies are now required to adjust the costs basis automatically when issuing distributions.
Keep high turnover mutual funds in tax-sheltered accounts
Rosenbluth says the main way to avoid the tax impact triggered by mutual funds' capital gains distribution is to hold funds 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. Mutual funds in Roth IRAs will avoid these taxes completely if owners follow certain rules. 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 holders 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, Dorwin says, especially at this time of year. "Investors can easily buy into a fund at just the wrong time and pick up that capital gains distribution, even if they didn't own the fund very long," he says. 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. "Wait until the end of the activity date to purchase the fund," he says.
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