Taxes can be a significant drag on portfolio performance over time, especially if you aren't careful. A Morningstar study of pre- and after-tax investment returns from 1926 to 2021 showed that taxes may reduce portfolio returns by up to 2% annually on average for investors who do not account for them when making investment decisions.2
While techniques such as tax-smart asset location and tax-loss harvesting may be effective in reducing an investor's exposure to taxes, there is still the possibility that you may be surprised by a tax obligation that you didn't expect—and may be largely outside of your control.
Paying taxes on losses?
Most investors understand that when they sell a security in a taxable account for more than what they paid for it, they will have to pay capital gains tax on the difference. Depending on your income, you may be required to pay up to 20% in capital gains tax on realized gains, assuming you held the security for more than 1 year. (Realized gains for securities held for less than 1 year are taxed as ordinary income.)
In some circumstances, however, an investor may be required to pay capital gains taxes on an investment that they may not have even sold and that perhaps even declined in value.
How is this possible? If you own a mutual fund, it could happen to you.
How mutual funds work
To understand why this can happen, it's important to understand how mutual funds function.
Mutual funds are baskets of securities, the composition of which is managed by investment companies. Throughout the year, fund managers may buy and sell securities to adjust the composition of the fund to better respond to market conditions, investment objectives, or, in the case of passively managed index funds, to better track a specific market index.
In the process of selling these securities, the fund managers may be able to harvest losses that reduce the overall tax exposure of the fund; however, when they sell securities that have appreciated in value and realize a gain, the fund incurs capital gains tax—and that tax burden is passed on to you, the investor.
Here's the tricky part: A fund manager can realize gains on individual securities even when the overall basket of securities loses value. That means you, the investor, may be paying taxes on realized gains for a mutual fund that is worth less than it was when you bought it and that you haven't sold. Worse yet, if you invest in a mutual fund late in the year, you're on the hook for any tax incurred over the entire calendar year even though you weren't invested at that time. This was especially acute in 2022 when, following many years of gains, some fund managers responded to the appearance of a bear market by selling off appreciated assets.
Indeed, in 2022, two-thirds of mutual funds made capital gains distributions even though the S&P 500 declined more than 18%.3 On average, it's estimated that those distributions came out to 7% of the investments in those funds, leaving many investors with a tax bill they may not have expected.4
Tactics for reducing your exposure to capital gains taxes
If you want to help avoid falling into this sneaky tax trap, there are several options available to you:
- Make sure your investments are in the appropriate accounts. If you are interested in a mutual fund that generates capital gains distributions, consider holding the fund in a tax-advantaged account such as an IRA or 401(k), rather than a taxable account.
- Seek out tax-managed mutual funds. Some mutual funds explicitly call out tax efficiency as an objective, and while they will not be free from capital gains distributions, they may be more efficient than funds that do a lot of trading and do not take the ultimate tax burden on the investor into consideration.
- Consider swapping out your mutual funds for exchange-traded funds (ETFs). ETFs may be more tax-efficient than mutual funds because the underlying securities in the fund are often traded "in-kind," that is, swapped for another security of similar value rather than sold outright. While ETFs do still distribute capital gains to investors, they tend to do so less frequently, providing some relief from taxes relative to mutual funds.
- Explore the potential benefits of a separately managed account (SMA). An SMA is similar to a mutual fund or ETF in that it is a basket of individual securities managed by professional asset managers. One area where it differs is that you own the underlying securities directly and have a say in how the basket is composed. Investors can work with their advisor to choose the SMA that fits their particular needs and objectives. Holding stocks directly may help enable strategic tax management, such as tax-loss harvesting, which may result in a smaller tax bill when implemented in taxable accounts. Investors may additionally be able to customize that SMA by telling their advisor what stocks or industries to exclude from the portfolio, providing greater flexibility and more personalization than a traditional mutual fund or ETF. SMAs can be held in both taxable and retirement accounts but potential for the tax benefits are reserved for the taxable accounts. Owning an SMA in a taxable account helps investors with the capital gains distribution dilemma—capital gains taxes are only owed when the individual securities in the SMA are sold for a profit. Often, a focus on tax-smart investing strategies,5 such as tax-loss harvesting, within SMAs can help offset some of the realized gains created by those sales. There may be additional tax benefits, as well. For instance, because you own the individual securities directly, you may have the option to gift those appreciated securities to charity without selling them. This would allow you to deduct the fair market value of the gifted security from your taxes while avoiding the need to pay taxes on the gain.
Keep more of your money and keep it working for you
Keeping more of your money in your portfolio and in the market is the best way to potentially benefit from long-term, compounding growth. By taking every opportunity to help reduce your overall tax burden, you may be better positioned to reach your investment goals.