Written by Thomas M. Geier, CPA, CFP®, PFS
Many investors are expecting 2015 to be a banner year for mutual funds to distribute their embedded capital gains to their shareholders. Why? One reason is that the equity bull market since 2009 has allowed fund managers to hold onto their stock picks for years and accumulate substantial price gains. However, 2015 has basically been a flat year and that may be evidence that managers have now sold some of those long term holdings. In addition, many mutual funds had experienced significant losses in the financial crisis of 2008 and were able to offset gains with those losses over the last few years. Now those carry-forwarded losses are used up.
One other reason is that companies have grown in market capitalization over this bull market. Mutual fund managers of diversified funds are required to sell shares of any concentrated holding once it goes over a set percentage, usually 5%. This may have been necessary this year. Also, small- and mid-cap companies may have grown beyond the asset class definition of some fund prospectuses, also forcing sales by the managers.
Mutual funds are not like other businesses that pay their own taxes. They are “pass through entities” that distribute their taxable gains and losses to the shareholders who own the fund, usually documented on a 1099 form. These shareholders then include this information on their own personal income tax return.
As a mutual fund shareholder, this may impact you mainly through timing mismatches. What causes capital gains distributions is a taxable event that happens when the mutual fund manager sells a stock within the fund. This can take place at any time and sometimes does not correlate to the increase in the value of the mutual fund while you own it. For example, if you owned a mutual fund during 2013 which was invested similarly to the S&P 500, you would have seen your fund statement increase by about 30 percent. However, you would experience a taxable event and pay any taxes on that gain only if the fund manager sold stocks during that year or you sold the fund itself.
Unfortunately, this year you may see a flat or even negative return on your statement, yet still receive a gain passed through to you. Remember, these gains have built up over the years and are just now becoming taxable transactions. And those investors who just purchased the fund in 2015 may receive a 1099 even though they did not experience the gains from the prior years as the fund profited from the bull market. This can be perceived as very unfair to those shareholders who believe they have to pay taxes on benefits they did not receive.
Is this valid? No, because all capital gains distributions are accompanied by an offsetting adjustment to the Net Asset Value of the fund. What this means is that the current shareholder unrealized gain is adjusted up or down to compensate for the taxable gains listed on any 1099. Yes, the shareholder will need to reflect any capital gains distributions in this year’s tax return, but will get that back when they finally sell their shares of the mutual fund itself.
Should you try to sell your current funds to avoid capital gains distributions? In general, no. Tax considerations should never be the main factor in your investment decisions. If the mutual fund is a good fund and you are happy with its future prospects, don’t worry about those distributions. Also, if the mutual fund is held in an account that is sheltered from taxes, such as a 401k or IRA, you needn’t worry about distributions.
Are there exceptions? Sure. If the passed through gains or losses will dramatically impact your own personal tax situation this year, you may want to sell the fund and buy a comparable investment. It is usually not advisable to sell the fund before the record date and then buy it back after the date to avoid the distribution. You most likely will become subject to the IRS’ Wash Sale Rules.
Most fund distributions are long term in nature. However, if a fund announces a sizable short term gain, this may impact your tax situation to a greater degree, if your personal tax rate is greater than the long term rate of 20%.
You can obtain information on the potential gains and losses set to be passed through to you by going to the fund web site. The funds will display the expected distribution amounts, whether they are short term or long term, and the date of record for shareholder ownership.
Over the long term, capital gains distributions from mutual funds are usually immaterial to the total return the investor experiences. However, each investor is different and has unique tax concerns. If you have any questions on how mutual fund distributions may affect you, feel free to contact us. We can discuss with you possible actions that may benefit you based on your situation.
© Geier Asset Management, Inc. December 2015. Thomas M. Geier is a Vice President of Geier Asset Management, Inc., a Registered Investment Advisor. The above blog reflects the opinions of Mr. Geier and not necessarily the firm. Any advice given is general in nature and investors must consider their own individual circumstances. Past performance is no indicator of future performance. The firm makes no warranties or representations of any kind relating to the accuracy or timeliness of the information provided.