Personal Finance: Capital gain distributions from mutual funds are coming

Personal Finance: Capital gain distributions from mutual funds are coming

November 15th, 2017 by Christopher A. Hopkins in Business Diary

If you own open-end mutual fund shares outside your IRA or other tax-deferred accounts, be on the lookout for the tax man. It's that time of year again, when funds make required distributions of realized capital gains to shareholders, who must in turn report these gains to Uncle Sam. This annual rite is often misunderstood, but is an important consideration in managing your investment portfolio.

When you buy an individual stock, your ultimate capital gain or loss is determined at the time of sale. This allows you to control the timing of any tax bill that may arise from the appreciation in your investment. Mutual funds are treated somewhat differently owing to the fact they consist of multiple investments, some of which may be sold throughout the year. 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.

Mutual fund companies generally make every effort to minimize tax liability to their investors. But there are times during which the funds must sell holdings to raise cash, especially if there are significant redemption requests from holders wanting some or all of their money. The fund manager will often be forced to sell positions with embedded capital gains in order to raise cash, and it is these realized gains that must be passed along to shareholders.

Christopher Hopkins

Christopher Hopkins

Photo by Contributed Photo /Times Free Press.

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, index ETFs rarely pay out capital gains distributions, allowing investors to better control the timing of their tax obligations much like our previous example of individual stock holdings.

Capital gain distributions also 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, which are less common, 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 it is usually not an optimal strategy.

There is a bright side. The reported taxable distribution can usually be reinvested back in the fund. This allows you to incrementally increase the cost basis in your overall position, reducing future tax liability.

Estimated gain distributions are particularly important for investors considering a new purchase of a mutual fund. Be careful in making your purchase before the year-end distributions (generally late November to mid-December). You could find yourself paying taxes on capital gains in which you did not participate. Think about 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 they come with their own unique caveats for taxable investors.

Christopher A. Hopkins, CFA, is a vice president and portfolio manager for Barnett & Co. in Chattanooga.

Getting Started/Comments Policy

Getting started

  1. 1. If you frequently comment on news websites then you may already have a Disqus account. If so, click the "Login" button at the top right of the comment widget and choose whether you'd rather log in with Facebook, Twitter, Google, or a Disqus account.
  2. 2. If you've forgotten your password, Disqus will email you a link that will allow you to create a new one. Easy!
  3. 3. If you're not a member yet, Disqus will go ahead and register you. It's seamless and takes about 10 seconds.
  4. 4. To register, either go through the login process or just click in the box that says "join the discussion," type your comment, and either choose a social media platform to log you in or create a Disqus account with your email address.
  5. 5. If you use Twitter, Facebook or Google to log in, you will need to stay logged into that platform in order to comment. If you create a Disqus account instead, you'll need to remember your Disqus password. Either way, you can change your display name if you'd rather not show off your real name.
  6. 6. Don't be a huge jerk or do anything illegal, and you'll be fine.

Chattanooga Times Free Press Comments Policy

The Chattanooga Times Free Press web sites include interactive areas in which users can express opinions and share ideas and information. We cannot and do not monitor all of the material submitted to the website. Additionally, we do not control, and are not responsible for, content submitted by users. By using the web sites, you may be exposed to content that you may find offensive, indecent, inaccurate, misleading, or otherwise objectionable. You agree that you must evaluate, and bear all risks associated with, the use of the Times Free Press web sites and any content on the Times Free Press web sites, including, but not limited to, whether you should rely on such content. Notwithstanding the foregoing, you acknowledge that we shall have the right (but not the obligation) to review any content that you have submitted to the Times Free Press, and to reject, delete, disable, or remove any content that we determine, in our sole discretion, (a) does not comply with the terms and conditions of this agreement; (b) might violate any law, infringe upon the rights of third parties, or subject us to liability for any reason; or (c) might adversely affect our public image, reputation or goodwill. Moreover, we reserve the right to reject, delete, disable, or remove any content at any time, for the reasons set forth above, for any other reason, or for no reason. If you believe that any content on any of the Times Free Press websites infringes upon any copyrights that you own, please contact us pursuant to the procedures outlined in the Digital Millennium Copyright Act (Title 17 U.S.C. § 512) at the following address:

Copyright Agent
The Chattanooga Times Free Press
400 East 11th Street
Chattanooga, TN 37403
Phone: 423-757-6315