By Joel Chouinard, ChFC®

November 6th, 2024

Ever opened your mailbox to find a surprisingly large tax bill, even though you haven't sold any investments? Yeah, it's not a fun feeling. This can happen because of something called "capital gains distributions" from mutual funds.

Okay, let's break this down. Mutual funds are like big baskets of different stocks and bonds. When you invest in a mutual fund, you're buying a tiny piece of that basket. Now, sometimes, the fund manager decides to sell some of the positions in the basket – maybe a stock that's gone up in value. When they sell something at a profit, it's called a capital gain. And guess what? They share that profit with you, the investor!

Sounds nice, right? Well, here's the catch: they also share the tax bill with you. This is done through capital gains distributions, which usually happen toward the end of the year. And these capital gains distributions are taxable, even if you don't actually see the money (because it gets reinvested). It's like getting a bonus at work that you immediately put back into your savings account – yet you still have to pay taxes on it. Many investors don't realize this, and it can lead to a nasty surprise come tax season, especially when the market has done well.

 

So, What Exactly Are Capital Gains Distributions?

 

Imagine you buy a share of a company for $50, and it grows to $80. If you sell it, you've made a $30 profit, which is a capital gain. With mutual funds, the fund manager is buying and selling positions within the fund all the time. When they sell something for a profit, they distribute that profit to you, the investor, and you are responsible for your share of the taxes via capital gains distributions. These capital gains distributions are calculated as a percentage of the mutual fund’s Net Asset Value (NAV) at the time of the distribution. For example, let’s say you own 1,000 shares of a mutual fund that is trading at a NAV of $100 (total investment of $100,000), and the fund manager announces a 3% long-term capital gains distribution.  You would be distributed $3 per share (3% of $100) and would owe taxes on $3,000 of long-term capital gains  ($3/share X 1,000 shares). That’s true even if you just bought those shares a week before the distribution and haven’t sold any of your positions. Brutal, right?

In addition to these mandatory capital gains distributions, you will also owe taxes when you sell your shares of the fund for a profit. The tax rate on the sale will depend on how long you hold the shares.

 

Why Can Distributions Lead to a Big Tax Bill?

 

There are a few reasons why these distributions can really add up:

• Market performance: When the stock market is doing well, fund managers are more likely to lock in some of the gains and sell positions at a profit to rebalance their portfolio, leading to bigger distributions.
• Fund manager style: Some mutual fund managers constantly buy and sell stocks and bonds to beat the market. This high turnover rate can generate more capital gains.
• Tax-inefficient funds: Not all funds are managed with taxes in mind. Some are more likely to generate taxable distributions than others.
• Change in fund manager: When a new manager comes in, that manager may have a slightly different investment philosophy, which could lead to more buying and selling.

 

How Can Attorneys Avoid Getting Slammed with a Big Tax Bill

 

The good news is there are ways to minimize the tax impact of these distributions:

• Use Index ETFs instead of Mutual Funds: Index ETFs are a great option. Unlike actively managed mutual funds, which make bets on winners and losers to beat the market, index ETFs simply try to match the performance of a specific market index (like the S&P 500). Because of this passive, buy-and-hold approach, they don't generate a lot of buying and selling, which leads to fewer capital gains distributions.
• Maximize tax-advantaged accounts: If you hold your mutual funds in a retirement account like a 401(k) or IRA, you won't owe taxes on the capital gains distributions until you withdraw the money in retirement.
• Timing your purchases: If you’re buying a mutual fund, avoid buying right before the capital gains distribution. You can usually find information about a fund's distribution schedule on its website.
• Tax-loss harvesting: This is a fancy term for offsetting your gains with losses from other investments. Doing so could reduce the impact of the capital gains distributions. Talk to your financial advisor about how this works to ensure you follow the wash sale rules.

 

Final Note

 

Capital gains distributions are just a part of investing in mutual funds. By understanding how they work, you can make smarter choices and avoid an unexpected tax bill. Do your research, consider your options, and don't hesitate to ask a financial advisor for help. After all, you work hard for your money – don't let a surprise tax bill take a big bite out of it!

 

SharpEdge Financial LLC is a registered investment adviser registered with the State of Texas. Registration does not imply a certain level of skill or training. The views and opinions expressed are as of the date of publication and are subject to change. The content of this publication is for informational or educational purposes only. This content is not intended as individualized investment advice, or as tax, accounting, or legal advice. Although we gather information from sources that we deem to be reliable, we cannot guarantee the accuracy, timeliness, or completeness of any information prepared by any unaffiliated third-party. When specific investments or types of investments are mentioned, such mention is not intended to be a recommendation or endorsement to buy or sell the specific investment. The author of this publication may hold positions in investments or types of investments mentioned. This information should not be relied upon as the sole factor in an investment-making decision. Readers are encouraged to consult with professional financial, accounting, tax, or legal advisers to address their specific needs and circumstances.