One of the most significant downsides of investing in mutual funds in non-retirement accounts is that they are required to make annual distributions of virtually all capital gains recognized during that year. This article highlights potential issues and steps that should be taken when capital gain distributions are projected to be received in non-retirement accounts. If you own a mutual fund in a retirement account, capital gain distributions are nonevents since taxes are only owed when a distribution is taken from the retirement account.
It is natural to think capital gain distributions are a good thing. The fund made money, and I am getting my share of the profits. If you own a mutual fund in a non-retirement account, in almost all circumstances, you will prefer not to receive a capital gain distribution. Why this is the case has to do with how capital gain distributions work.
When a capital gain distribution is made, the fund’s price will decline by the percentage of the distribution. If a fund makes a 10% capital gain distribution, the fund’s price will drop by 10%, reflecting that some of your invested value is leaving the fund and being paid to you directly. If you reinvest your capital gain distributions “as almost all investors do”, at the end of the day, you will own more shares, but the dollar value of your investment will not change. Assuming dividend reinvestment, if your investment was worth $100,000 before the distribution, it will still be worth $100,000 after the distribution but spread across more shares. The unwelcome news is that you will owe taxes on the amount of the distribution even if you reinvested the dividends.
The worst thing about capital gain distributions is that they are calculated at the fund level and have no relation to the performance experienced by the individual investor. For example, an equity fund that sells Tesla stock in 2022 after owning it for ten years will have a significant capital gain. The gain to be distributed would be the difference between the price paid by the fund for Tesla stock many years ago and the sales price. If you first became an investor in the fund in 2022, you would be taxed on the full amount of the gain, just like the investor who has owned the fund for 10 years. To minimize potential tax liability, you will need to research the projected capital gain distribution for each equity fund owned. Beginning in October each year, mutual fund, companies will distribute estimates of upcoming capital gain distributions. These distributions will be payable to shareholders of record at close of business on a specified date (usually in December of each year). The amount of the projected capital gain distribution is generally expressed as a percentage of the value of the fund. Let’s say a fund indicates that the gain is estimated to be 8% to 10%. If you own $100,000 of the fund your taxable capital gain distribution will be $8,000 to $10,000.
Three Investor Scenarios Explained
Let us review three examples to help you understand when you should take steps to minimize the tax consequences of mutual fund capital gain distributions. Three investors own ABC fund, which just indicated it will pay a 10% capital gain distribution to shareholders that own the fund on December 3, 2022. Assume today is December 2, 2022.
- Marcie bought ABC fund five years ago. With reinvested dividends, her tax basis is $50,000, and the value of the fund is $100,000 ($50,000 gain). From a tax perspective, if the gain that would be recognized upon the sale of the mutual fund is greater than the amount of the distribution, the best action is to hold the position and receive the capital gain distribution. If Marcie reinvests the $10,000 capital gain distribution, her tax basis will go to $60,000, and her invested value in ABC fund will continue to be $100,000. She will also own more shares of ABC fund given that she reinvested her distribution.
- Jill invested $100,000 in ABC fund on December 1, 2022, and her current invested value is $100,000 (0% return). Jill should sell the fund to avoid receiving a $10,000 taxable distribution when she has not made money. If she does not sell and reinvests the distribution, her basis will be $110,000 with a $100,000 value.
- Paul invested $120,000 in ABC fund in January of 2022. Due to the declining stock market, his invested value is currently $100,000 ($20,000 loss). Paul’s situation is of particular concern. If he sells the ABC fund prior to the close of business on December 3, 2022, he will recognize a $20,000 capital loss that can be used to offset capital gains. This is the correct action to take. If he overlooks this opportunity, he will receive a $10,000 taxable distribution, even though he has lost money on his investment. His tax basis in ABC fund will be $130,000, and his invested value will be $100,000.
It is extremely important if you own equity mutual funds in non-retirement accounts to monitor the projected capital gain distributions for 2022. Specifically, you should take action to sell a fund prior to its record date  if one of the two situations exist:
- You would recognize a capital loss by selling a mutual fund.
- The capital gain distribution being paid by a mutual fund is greater than the gain that would be recognized upon sale of the fund.
With the market decline and many funds experiencing significant outflows, the likelihood that equity funds will make large capital gain distributions increases. Projected capital gain distribution information is just starting to become available. You will need to act before the fund’s distribution record date passes, which usually falls in early December. Do the necessary research or reach out to your financial advisor to ensure you do not get caught paying taxes that could have been avoided.
Robert Steinberg, JD, CPA, CFP®, is founder & CEO of Blue Chip Partners , a registered investment advisory (RIA) firm headquartered in Farmington Hills, Michigan that provides highly personalized financial planning and portfolio management services to over 700 clients. Robert began his career specializing in tax preparation and planning at Deloitte and went on to practice as an estate-planning attorney for Honigman, Detroit’s largest law firm. www.bluechippartners.com