Capital Gains Distributions: The Hidden Side Of Mutual Fund Investing
By Gordon Nesbit | CFP®, CIMA®, RMA®, CRPS®, CPFA®
Over the past several decades, investors have steadily poured their investment dollars into mutual funds and Exchange Traded Funds, seeking shelter from risk through the inherent diversification offered by these investment vehicles. In fact, from June 2000 to June 2022, total net assets held in mutual funds alone rose from $7,113 billion to $22,248 billion! Despite the apparent love for mutual funds, it is important to understand a hidden side of mutual fund investing – the capital gain distribution!
When it comes to individual investing, there are two potential sources of capital gains. First is shareholder transactions. These are the more common – or at least more commonly-known – transactions. Selling an asset for more than the purchase price creates a capital gain that is subsequently taxed at the prevailing capital gains tax rate, usually 15% or 20%, depending on an individual's tax bracket.
The second source of capital gains comes from mutual fund capital gain distributions. Mutual funds generate capital gains and losses as the fund managers trade securities throughout the year in response to individual company financial data, short-term performance projections, and even shareholder requests for redemptions. Per IRS regulations, mutual funds must distribute their annual realized net capital gains to shareholders.
As an individual investor, you may not even notice that this has happened. The distribution of capital gains decreases the fund's share price by the amount distributed. For example, a mutual fund with a share price of $20 may pay a $3 distribution to shareholders. Thus the fund's share price drops by $3 to $17. If you choose to have your capital gains reinvested (as most long-term investors do), you will still own the same amount of dollars of the fund, just more shares at a lower price than before the distribution and subsequent reinvestment.
Assuming the fund is held in a brokerage account (not an IRA, 401(k), or another qualified retirement plan), capital gains tax is due on the distribution in the year of the distribution. If your mutual fund distributes capital gains, you will find it on Schedule D of your tax return. In the example below, the taxpayer made voluntary shareholder transactions yielding $13,177 of taxable gains, but he also had $1,790 of taxable capital gains distributions forced upon him by his mutual funds.
At Hurlow Wealth Management Group, we recommend holding only tax-efficient or tax-managed mutual funds in brokerage accounts. Exchange Traded Funds are generally more tax-efficient than mutual funds, but they, too, should be evaluated for capital gains distributions. Unfortunately, some actively managed mutual funds churn out sizable capital gains distributions – upwards of 15% to 20% – every year, making them very poor securities to hold in brokerage accounts, especially during your highest-tax-liability years.
Time To Sell?
To mitigate against this situation, each December (when most mutual funds push out capital gains distributions to shareholders), we research every mutual fund that our clients own in brokerage accounts to determine the upcoming capital gains distributions. If the anticipated capital gains distribution is greater than our clients' current unrealized capital gain, it is advantageous to sell the fund, pay the lower tax liability, and avoid the higher tax bill coming in April of the following year. Even if the expected capital gain distribution is lower than the current unrealized capital gain of the investor, it may still be advantageous to sell the fund if it is a "repeat offender" that distributes unsolicited capital gains every year.
Mutual funds are a great way to diversify your investment portfolio, but they do come with some costs. Capital gains distributions are one of those hidden costs that should be evaluated and considered before investing.
If you would like to learn more about capital gains distributions, tax-efficient investing, or our advanced financial planning strategies, please contact any member of the Hurlow Wealth Management Group.