Tax Planning for Mutual Fund Capital Gain Distributions

Investor Beware of Year-End Capital Gain Distributions!

In Asset Allocation, General Financial Planning, Investments, Personal Finance, Personal Financial Planning, Tax by Chip Hymiller

It looks like 2014 is going to be a huge year for mutual funds making capital gain distributions.  While on the surface capital gains sounds like a good deal – after all isn’t the point of investing to create investment gains?  However, in reality capital gain distributions from mutual funds can pose a tax nightmare for some investors – especially for those who invest in mutual funds in non-retirement (taxable) accounts. We believe that getting an idea of a mutual fund’s capital gain distribution estimates should be an integral component of your year-end tax planning process.

Tax Planning for Mutual Fund Capital Gain Distributions

What are capital gain distributions?

Capital gains are generated when one sells an investment at a price higher than what was originally paid for the investment – the profit.

Within mutual funds, a portfolio manager buys and sells investments.  When there is a net investment gain on these transactions, mutual funds are required to distribute capital gains to investors of the mutual fund. These capital gain distributions are reported on a 1099 form and taxable.

Do you have to sell a mutual fund in order to trigger these gains?

No – capital gains are triggered, not by you selling the fund, but rather by the mutual fund manager selling individual investments at a gain within the fund itself.

How can a mutual fund have a capital gain distribution when performance has been negligible or even negative?

Internally, mutual fund managers buy and sell stocks, bonds, etc.  Even though a mutual fund may have poor performance for the year, the fund manager could have sold investments that have been owned for many years and actually have a gain. Mutual funds are required to pass these gains on to its investors.

Are you taxed on gains even if you have a loss in the mutual fund?

Yes.  In fact, if you aren’t careful, you can invest in the mutual fund the day before the capital gain is distributed and actually be taxed on the full amount of the capital gain distribution as if you had owned the fund for an extended period.  This year, we have identified several funds that are distributing capital gains of 40% or so of their net asset value.  This means that you could invest $10,000 in a mutual fund and the next day receive (and be taxed on) a $4,000 distribution – even though your total investment in the mutual fund is still only worth $10,000.

What if I reinvest dividends, are these capital gains still taxable?

Yes.  Capital gains distributions are taxable upon being paid to investors regardless of whether they are reinvested.

What can you do to minimize these capital gain distributions?

Invest in tax-efficient mutual funds or exchange traded funds.  We suggest that you consider utilizing low cost index funds – especially in personal brokerage or mutual fund accounts.

In addition, if you utilize the “select lot” portfolio accounting method, you could sell those shares whereby the capital gain distribution received from the fund will exceed the embedded (unrealized) capital gain.

Is my tax preparer aware of capital gain distributions when calculating my estimates and/or withholding rates?

Most CPAs and other tax preparers calculate estimated tax payments and withholding levels based on “last year’s numbers.”  This means that in years like 2014, when capital gain distributions are expected to be very high, your tax liability may have been underestimated and you could owe money (or get a lower refund) upon filing your return.

Is there a resource that you utilize to help estimate capital gain distributions for tax-planning purposes?

Normally, mutual fund companies report this information directly on their websites. However, the website provides capital gain distribution information for many mutual funds.