If you own traditional mutual funds in a taxable account (outside your IRA or 401(k)), be on the watch for your annual capital gains report. If your fund reports a gain, you will be required to pay taxes on it even if you did not sell any shares of the fund. This little ritual occurs each year about this time, as fund managers tally up the gains and losses from transactions within the fund and distribute the net proceeds to you, typically mid to late December. As that time approaches, here's what to expect.
With the increasing popularity of alternative pooled structures like Exchange Traded Funds (ETF), some clarification is warranted. By far, the largest class of common investment vehicles is the traditional open-end mutual fund. Dating back to the late 1920s, mutual funds have provided affordable and accessible access for average investors to the stock and bond markets. Today there are 8,000 separate funds in the US alone, totaling over $21 trillion in assets. This type of fund is typically identified with a five-letter symbol, like VFIAX or FCNTX.
By law, mutual funds are required to distribute realized capital gains and losses to fund investors each fiscal year when they are incurred. For example, if your fund sold its holding in Amazon and realized a gain of $1 million, each shareholder would receive a distribution representing their proportional share of that profit. In practice, the gains and losses are aggregated and distributed at year-end, broken into short-term and long-term gains depending on the holding period within the fund.
In this way, mutual funds are different than individual stocks. You settle up with the IRS only when you sell your stock and realize the gain. However, even if you sold no fund shares, you must still report the gain distributions from sales inside the fund. Again, this only applies to taxable accounts and not to IRAs.
In part because of this tax issue, ETFs have been gaining ground and now comprise about $4 trillion in assets in the United States. In general, ETFs are treated like individual stocks with regard to gains and losses, only rarely reporting gain distributions until you sell the fund. Mutual funds remain popular in retirement accounts since the tax question is moot, although the less costly ETF structure has increased their appeal here as well.
Fund companies begin their reporting period during late October. Investors receive notification of the expected distribution and the effective date. Shareholders may generally choose whether to reinvest the distributions back into more shares but are liable for the tax in any event if a gain is reported.
There are a few steps investors could consider. First, be wary of any new fund purchases prior to the effective date of the distribution. Be certain you know of any possible distributions that may lurk just ahead before plunging in.
You could choose to sell your shares before the effective date. However, this is generally not advised, since you may end up realizing other possibly larger embedded gains when you sell the fund shares.
You could also invest the distribution into equivalent ETF funds. This would allow you to shift gradually into a more tax-efficient and often lower-cost vehicle with the same investment objective. Then consider swapping the balance in a year with losses, or use realized losses from other investments to offset the gains and establish a more tax-friendly ETF position in which you control when to pay the tax.
Or just be glad you had a gain and send the money to Uncle Sam. He can use it this year.
Christopher A. Hopkins, CFA, is a vice president and portfolio manager at Barnett & Co. in Chattanooga.