If you haven’t already filed your tax returns or extensions, you still have until July 15 to do so. By now you should have gathered all the necessary forms and receipts. Hopefully you didn’t forget to include the capital gain distributions reported by your mutual funds on the 1099-DIV.
Realization of capital gains is a natural part of the investment process. After an initial investment, the goal is to sell that investment in the future at a gain, which the US government will tax. But things get a little more complicated when you consider a mutual fund investment. Let’s look at two scenarios where a mutual fund investor may end up paying more in capital gains taxes than expected.
Inheriting a mutual fund’s cost basis
After buying a mutual fund unit at a certain net asset value (NAV) and then selling it at a higher NAV, an investor pays capital gains tax. But the investor is also exposed to the decisions of the fund manager. If they sell a security at a gain, the investor receives what’s called a distributed capital gain and pays the tax on that sale. Of course it’s the manager’s job to buy stocks and sell them at a gain. But it’s important to remember that computed gains are based on the fund’s cost basis—not the investor’s.
Let’s say an investor buys units of a mutual fund. A few days later the manager decides to sell the fund’s position in a wildly successful mega-cap technology company. While the investor enjoys a few days of gains, the fund’s position in the company is years old, with a lower cost basis and a much larger associated gain. When the manager sells the position, the gains it realized over the years are distributed to the investor, who effectively inherits the cost basis of the underlying holdings in the fund.
Before buying into a fund, it’s a good idea to assess the amount of capital gains the fund is sitting on. Morningstar conveniently provides a measure called Potential Capital Gain Exposure (PCGE) for this very purpose. For example, a fund whose assets have appreciated by 40% has a PCGE of 40%.
Paying for another investor’s sale
Sometimes the pursuit of additional return—the principle of buying low and selling high—motivates a fund manager to sell securities. But sometimes the liquidity needs of other investors in the fund drive those sales. When a mutual fund investor decides to redeem their shares for cash, the portfolio manager may be forced to sell investments in order to satisfy the redemption. This sale may trigger a capital gain, which is distributed to the remaining shareholders.
Similarly, as some investors reduce their exposure to active management in mutual funds in favor of index exposure through ETFs and direct indexing solutions, the redemption of mutual fund shares could trigger large capital gain distributions for remaining shareholders.
Capital gain distributions in 2019 and onward
According to the Investment Company Institute, capital gain distributions from equity mutual funds in 2019 totaled $318 billion—lower than 2018 but still meaningfully large for the investors that receive them. Notice in the graph below that gain distributions were relatively light in the years following the global financial crisis due to the loss carryforwards from 2008. Funds were able to offset realized gains with loss carryforwards, suppressing the distribution of taxable capital gains to investors. That welcome vacation from gain distributions ended in 2013, when the funds used up their loss carryforwards and resumed the distribution of capital gains. Capital gain distributions since then have been strong, at two to four times the levels seen in 2008.
Notice as well that capital gain distributions hit a peak in 2018, a year in which the S&P 500® declined over 6%. Yet mutual funds distributed the highest aggregated capital gains ever recorded, and capital gains taxes were proportionately high—truly adding insult to the injury of the declining market.
Capital gain distribution by equity funds ($MM)
Source: Investment Company Institute, 2020 Investment Company Factbook, 5/6/2020. For illustrative purposes only. Not a recommendation to buy or sell any security.
This may prove to be a year of mixed results for mutual fund holders. Since dropping in February and March at the onset of the COVID-19 pandemic, the market has staged a huge recovery, even showing a positive year-to-date return on June 8. Market volatility remains high, with daily gains and losses of one to two percentage points. In times of high volatility and market weakness, outflows from funds tend to be heavy. Combined with high amounts of unrealized gains, these outflows could result in another year of large capital gain distributions.