Some time ago, I received a call from an upset man who received a $50,000 capital gain distribution from his mutual fund even though he has had a negative return this year. That means that he must pay tax on $50,000 and has no money to show for it. How can it be? It makes no sense unless you understand the makeup of a mutual fund.
A mutual fund is a collection of investments (usually stocks and bonds) owned by the fund’s shareholders. Mutual funds pay no tax because they pass through all gains to the shareholders similar to a partnership. Individual stocks owned by the fund may have been held in the fund for several years and experienced a gain. The tax on the gain is not paid until the stock is sold.
Along comes a down year in the market. The fund manager feels compelled to sell some stock to lock in gains as the market drops. As he or she sells, the locked up gain is realized and the fund has taxable income. At the end of the year, they distribute the gain to the shareholders. No actual gain occurred that year, but the tax is due for the previous year’s gains.
What should you do short term?
Sell the fund before the year ends. Maybe your cost basis (what you paid for the fund plus reinvested distributions) is higher than the value of the fund. In that case, you may be able to negate the effect of the tax distribution by selling the fund.
If you are buying mutual funds outside of a qualified plan (Individual Retirement Arrangements or Simplified Employee Pensions, for example), wait until after the fund has declared its annual capital gains distributions before making the purchase. Put it in the fund’s money market account until it is safe to invest in the fund. Failure to abide by this could lead to a large tax liability shortly after you purchase the mutual fund.
Stay calm. It is not an extra tax you are paying. Eventually, you would owe the tax anyway when you sell the fund. The only exception to this is called “stepped up basis.” You get it when you pass away owning an asset that has appreciated in value.
What should you do long term?
Buy tax-efficient funds. There are mutual funds that actively manage their buying and selling activity to minimize the capital gains distributions. They may sell a stock with a loss to offset a sale of stock with gains.
Invest in funds based on an index. There is little buying and selling in an index fund. This can significantly reduce your capital gains distributions. An index fund is based on a group of stocks that is tracked regularly in the marketplace. Indexes are created by companies such as Standard & Poors or the Dow Jones. They exist to help financial managers track the performance of the most widely held stocks.
Put money in a variable annuity. These are tax-deferred investment accounts sponsored by an insurance company. You pay no tax on the gains until you withdraw the money. They are designed to make payments to investors during the retirement years. If you take the money out of the annuity before age 59 1/2, you will pay a 10-percent penalty on the gains. Also, gains are taxed as ordinary income and do not qualify for capital gains treatment. Maximum federal rates for capital gains are 15 percent, where ordinary income can be taxed as high as 39 percent.
Utilize private investment management
A personalized investment portfolio is the key advantage to private investment management. Instead of a mutual fund, which is a “pooled investment account,” a client has a portfolio of individual stocks and bonds with names that they would recognize. The money manager can tailor the portfolio to their specific risk and return parameters so that volatility can be more predictable. The client has knowledge of each security they own, how much the management is costing them and the percentage rate the portfolio is earning after expenses. If managed properly, with low turnover, the private account can accrue unrealized capital gains over many years without the current tax burden of other investments. Unlike mutual funds, the private manager can time the purchase and sale of securities for the individual client’s tax benefit.
