If you own shares in a mutual fund, you may be in for a rude awakening come tax time. As part of the rules that allow mutual funds to avoid taxation at the fund level, mutual funds are required to distribute their realized capital gains to shareholders on an annual basis. Shareholders, in turn, are required to pay taxes on these distributed gains—an exercise that feels a lot like rubbing salt in a wound, especially after suffering through a bear market as we have this year.
Mutual fund companies usually give notice of estimated capital gains distributions sometime in November and distribute the gains in December. If you want to see what your mutual funds are expected to distribute this year, call your mutual fund help line or go to their website. Your financial advisor should also be able to help you.
In an ironic twist, market downturns often produce larger capital gains distributions than up markets, especially when the down market causes a large number of investors to sell a fund. The large sales required to fund the redemptions can generate significant capital gains. At the end of the year, the capital gains are distributed to the investors who remain in the fund, while the investors who sold their shares in the first place (and triggered the capital gains) walk away without the associated tax liability. Sometimes, life is not fair. (As an aside, you can avoid this potential problem by using exchange-traded funds instead of mutual funds.)
Other capital gains may be produced as a consequence of the fund manager’s normal day-to-day activity. While many active managers give some thought to the tax consequences of their actions, most do not make it a primary consideration. Even a small mutual fund will have thousands of investors, and the largest funds may have millions. Some of these investors will be IRAs or tax-qualified plans that do not pay taxes. Others will be high income investors who face the maximum marginal tax rate. With such a diverse group of investors it is impossible for managers to take into account every possible tax consideration.
Fund managers are almost always evaluated on their pre-tax performance. Before I started my wealth management firm, I managed several mutual funds for a division of American Express. My performance was almost entirely evaluated on how I performed relative to a peer group of funds without any consideration for the tax implications of my decisions. If my pre-tax performance was in the top decile of my peer group, I was rewarded well. The longer I stayed in the top decile, the larger my bonus grew. Highly-performing managers earned bonuses equal to several times the value of their base salary.
Because of these economic realities, fund managers are not going to spend much time thinking about the pain a capital gains distribution might cause you. However, this is something you and your financial advisor should definitely consider when you are evaluating potential investments. Two statistics can help you measure your exposure to capital gains distributions: the mutual fund’s portfolio turnover rate and its Potential Capital Gains Exposure (PCGE). Both statistics are available from Morningstar.
Portfolio turnover measures how quickly the securities in a mutual fund are bought or sold over a given period of time. The PCGE measures the proportion of the fund’s net asset value that is comprised of unrealized capital gains. A fund with high turnover and a large PCGE is more likely to make large capital gains distributions. If you are a high-income investor investing in a taxable account, you may want to avoid mutual funds with that kind of profile.
Some investors may be tempted to sell a fund prior to a capital gains distribution in order to avoid the capital gains tax. Granted, that might work in some circumstances, but you need to be careful. You need to consider the capital gains you might realize or the wash sale you might trigger when you sell the fund, as well as the potential upside you might miss if you sell a good performer. Once again, your advisor should be able to help you consider all the relevant factors.
Steven C. Merrell MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., an independent wealth management firm in Monterey. He welcomes questions you may have concerning investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to email@example.com.