If you own mutual fund shares outside of your IRA, be on high alert for the tax man. Funds generally announce their required distributions of realized capital gains around this time of year, so you should mind your timing of purchases and sales accordingly to avoid unanticipated tax liabilities.
Investors who buy and sell individual securities understand that they control when to fork over Uncle Sam's cut of the profits. Capital gains, for example, are recognized based on the date a stock is sold, and are deferred indefinitely as long as the holding is retained (and disappear entirely at death).
With mutual funds, not so much. The rules governing tax treatment of funds demand that certain profits and losses be passed along to investors each year. Typically, capital gains incurred throughout the year inside a mutual fund are distributed in November or December. Investors should make the effort to know when and how much a fund is expected to declare before either buying or selling near the end of the year.
Traditional open-end mutual funds are simply pools of investor cash lumped together to purchase a portfolio of stocks or bonds. During the year, positions are sold at a gain or loss based upon the fund manager's particular investment criteria. In addition, when investors decide to cash in their shares, the fund must sell securities to generate the proceeds to satisfy redemption requests, again forcing the fund to recognize gains or losses. If redemption requests are especially heavy, the fund manager may be forced to liquidate long-held positions with significant embedded gains to raise sufficient cash.
If the netting of all sales during the year results in a capital gain, the bulk of that gain must be paid out to fund shareholders, even if the holders do not sell any of their shares. This can sometimes come as an unpleasant surprise.
Exchange traded funds or ETFs have arisen as a significant challenger to traditional mutual funds, particularly in the passive index space, in part because of their relative tax efficiency. Owing to the difference in how ETF shares are constructed, passive ETFs like index funds rarely pay out capital gains distributions, allowing investors to better control the timing of their tax obligations much like they are able with individual stock holdings.
Capital gain distributions come in two flavors. Long-term gains arise from positions held by the fund for more than one year. These distributions are taxed at the same long-term gain rates as for individual stocks, currently 15 percent for most taxpayers. Short-term gains result from sales of investments held less than a year, and are generally subject to ordinary income tax rates.
Mutual fund companies typically publish a list of estimated distribution dates and amounts on their websites. Depending upon the magnitude of potential obligations, investors have the opportunity to plan for projected liabilities by realizing losses elsewhere or even selling some of the fund shares in advance of the payout. However, a sale may incur additional taxable gains that overwhelm the expected distributions, so this is often not a plausible strategy.
Gain distributions are particularly important for investors considering a new purchase. You could find yourself paying taxes on capital gains in which you did not participate. Consider holding off until after the distribution before buying in.
Certain funds have a greater propensity to pay gains, especially high-turnover funds with lots of transactions. Tax efficiency and low turnover are important considerations in taxable accounts, all else equal.
Mutual funds have been tremendous tools for individual investors, but it pays to understand their quirks.
Christopher A. Hopkins, CFA, is a vice president and portfolio manager for Barnett & Co., in Chattanooga