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Your Mutual Fund’s Unwelcome Gift

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If you hold stock mutual funds in your portfolio, you may have received an unwelcome gift this holiday season: capital gains distributions.

Mutual funds buy and sell securities all year long. At the end of the year, this means they have realized either an overall capital gain or loss on their trades. If it is a loss, the fund simply carries the loss forward, and shareholders don’t need to worry about it. If it is a gain, however, the law requires that mutual funds distribute it to shareholders. Mutual funds typically make such distributions in December.

Unfortunately, these distributions come with tax obligations for the shareholders if they own their shares in a taxable account rather than, say, a tax-sheltered retirement plan. Net short-term capital gains are taxed as ordinary income, and long-term capital gain distributions are subject to generally lower capital gains tax rates. (Long-term and short-term capital gains are determined by how long the mutual fund held the securities in question, not how long the shareholder has held shares of the fund.) Shareholders can reinvest distributions or take them in cash, but owe tax either way.

When funds distribute relatively small amounts, this process is an annoyance. But in recent years, it has not been uncommon for some funds to make very large distributions, routinely as large as 10 percent of the fund’s total value and sometimes significantly more. Wells Fargo’s Disciplined Small Cap Fund said it would distribute 47 percent of its assets as taxable gains in December, because new managers taking over the fund mid-year sold much of the fund’s holdings in order to start fresh. Investors are understandably distressed when they suddenly find a significant portion of their investment unexpectedly has become taxable.

There are two significant factors driving these large distributions. First, some funds simply trade securities frequently, and in consequence realize large gains as markets climb. This is why you see few large distribution from index funds, which trade relatively little compared to their actively managed counterparts. Given the historically long bull market that only recently either stalled or ended (it will take some time to know which), many funds have racked up large unrealized gains and eventually will sell those appreciated securities, leading to more capital gain distributions. Second, sometimes funds must sell a substantial portion of their securities in order to meet redemption requests from shareholders throughout the year, which can trigger large capital gains if the fund doesn’t have enough securities it can sell at a loss. In fact, some of these requests may come from shareholders who hope to avoid capital gain distributions, a situation that is more or less the investing equivalent of a game of hot potato.

Exchange-traded funds generally do not expose their shareholders to significant capital gain distributions because of the way they are structured. And bond mutual funds seldom face this problem, because compared to stock funds, their value doesn’t rise as quickly. However, for actively managed stock mutual funds – especially those that do not employ a buy-and-hold strategy – these capital gains distributions can represent a major problem, and one that is unlikely to go away. Some funds may even give up, liquidating entirely if redemption requests arrive in force, especially if the fund faces other performance problems.

To see why major capital gain distributions can contribute to increased redemptions, imagine that an investor named Jake owns $100 in mutual fund shares, with a basis of $100. The mutual fund is currently priced at $100 per share. At year-end, the fund makes a 20 percent capital gains distribution, which is $20 per share in this instance. Now the price per share has become $80, leaving Jake with an unrealized $20 loss. Jake also has a capital gains tax bill on the $20 distribution. To avoid paying tax, Jake should sell his remaining shares and realize the loss to offset his capital gains tax. At Palisades Hudson, we have found ourselves engaging in this exercise often at year-end the last few years, in order to help clients avoid capital gains tax when possible.

Actively managed mutual funds are seeing investors flee for index funds. In the current market environment, actively managed funds have struggled to compete on performance or fees. The year-end tax hit from capital gains distributions is one more strike against them, and it may be a problem for years to come.

Mutual fund industry leaders have sometimes attempted to interest lawmakers in acting to change this system. In 2001, they attempted to encourage Congress to allow shareholders to defer tax on capital gains distributions until they sold their shares. Rep. Paul Ryan, R-Wisc., introduced a bill to this effect in 2003, but the legislation did not succeed. In fact, every time a legislator has attempted to address this issue, the attempt has gone nowhere. Some commentators raised the subject again following the 2008-09 recession, but legislative appetite for this change simply has not materialized.

For now, investors should keep an eye on their mutual funds, especially actively managed stock funds. If you got hit with a large distribution in 2018 and don’t want to repeat the experience, you can consider talking to your financial adviser about whether adjusting your portfolio makes sense given your overall financial goals. Avoid purchasing shares just before a major planned distribution and consider whether tax-efficient alternatives may better suit your investment goals. Revisit your asset location strategy (that is, holding tax-efficient assets in taxable accounts and tax-inefficient assets in tax-deferred or tax-free accounts). And if you were considering selling a particular fund regardless, doing so before a distribution is usually smart; just bear in mind that you cannot re-purchase shares of the same fund sold at a loss within 30 days, or you risk running afoul of the Internal Revenue Service’s wash sale rules. You may also be able to offset part or all of your capital gain distribution through tax-loss selling.

In the meantime, make your peace with any unwelcome year-end gifts from 2018. Unfortunately, capital gains distributions – and the tax bill that comes with them – are a present that can’t be discreetly returned now that the holidays have ended.

Managing Vice President Paul Jacobs, of our Atlanta office, is among the authors of our firm’s recently updated book, Looking Ahead: Life, Family, Wealth and Business After 55. He wrote Chapter 12, "Retirement Plans"; Chapter 15, "Investment Approaches And Philosophy"; and Chapter 19, "A Second Act: Starting A New Venture." He also contributed to the firm’s book The High Achiever’s Guide To Wealth.

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