Mutual funds have served a laudable role in making investing accessible to millions of Americans and they continue to dominate the retail investment landscape. But be on the lookout for tax surprises as we draw closer to year end if you hold mutual funds in a taxable account. Fund investors in tax deferred accounts like IRAs and 401(k)s can stop here and skip ahead to Beetle Bailey.
Investment funds represent large pools of investor capital being managed to a specific objective. Throughout the year, the fund manager buys and sells securities to adjust to changing fundamentals in the underlying stocks. The fund must also respond to new cash inflows with more purchases, and to requests for redemptions by selling some of its current portfolio. Each sale transaction results in either a capital gain or loss which must eventually be passed along to the fund shareholders.
This process typically occurs during November and December. Gains and losses from portfolio transactions are netted against each other and the net gain (or loss) is paid out to shareholders, creating a tax event.
Here's how it works. Suppose you own 500 shares of stock mutual fund XYZ, currently valued at $10 per share for a total value of $5,000. As the result of various sales from the portfolio, the fund company reports to you a 10% capital gain distribution of $500. This $500 gain is paid out to you (credited to your fund account), and the market value of the fund (called the net asset value or NAV) is reduced by $500, leaving an NAV of $4,500.
In most cases, the distribution is automatically reinvested in more shares of the fund, bring your NAV back to $5,000. However, you will now receive a sweet little note on your form 1099 reminding you of your obligation to pay taxes on the $500 distribution. And although this happens every year, investors often forget or simply misunderstand the implications since their net position remained unchanged.
Once the distribution is reinvested, your cost basis in the fund is adjusted to reflect the additional $500 you bought with the distribution. So while you pay up this year, you also reduce your longer-term tax burden down the road.
You also have the option of not reinvesting, leaving you with the lower $4,500 NAV and $500 in cash. Still gotta pay the taxes, though.
The magnitude of any reported gains varies greatly depending upon several factors, particularly the frequency of trading or "turnover" in the fund: high-turnover, rapid-fire funds generally report more gains or losses than relatively passive flavors like index funds.
As with any other investment, mutual funds will also accrue unrealized gains or losses based upon holdings in the fund that are not sold and which you would realize only upon the sale of your shares. However, these gains are somewhat mitigated over time by the annual distributions.
Mutual fund companies publish their scheduled capital gains distributions on their websites beginning around mid-November. It pays to check this out if you are considering a purchase, and be sure to wait until after the distribution so you don't receive a tax bill you didn't earn.
Depending on your cost basis and how long you have held the fund, it might also be worth evaluating whether to sell before the distribution and either repurchase later at the reduced NAV or migrate to a more tax-efficient vehicle like an equivalent ETF. ETFs operate much like mutual funds but usually allow the investor more control over timing of gains and losses.
Happy Holidays from Uncle Sam.
Christopher A. Hopkins, CFA, is vice president and portfolio manager for Barnett & Co. in Chattanooga.