Managers and other shareholders play a big role in the amount of tax you pay on capital gains in your mutual funds. Are you prepared to take the hit?
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.
Inheriting a mutual fund’s cost basi
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.
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)
What’s a mutual fund investor to do?
The bottom line
It’s quite a surprise to have tax day in the summer this year. Many investors may be even more surprised with the capital gain distributions from their mutual fund holdings and the resulting tax bill. Custom SMA solutions—as either a replacement for or a complement to mutual funds—allow greater flexibility, control, and predictability when it comes to capital gain management.