Tips for Minimizing Capital Gains Distributions from Funds
/By Shelley Murasko
Each December, mutual fund companies are required to account for all the gains resulting from the buying and selling of holdings within the funds throughout the year. This calculation is called the “capital gains distribution,” and it’s the investor's pro-rata share of the proceeds from the fund's transactions.
The distribution is then issued to each investor holding part of that fund on the ex-dividend date. This typically occurs a few days before the capital gains distribution is paid.
These distributions are taxed as long-term capital gains and can have significant tax ramifications for investors with large, taxable brokerage accounts. This impact will appear on the investor’s 1099 Composite Form from their brokerage firm, showing Capital Gains Distributions on line 2a. The form is usually sent out in February.
To be clear, this is an additional taxable event for holding a mutual fund. It has nothing to do with the capital gains that an investor can incur by selling a fund in the future. These capital gains distributions will occur annually, even if the investor holds the fund for decades.
What You Need to Know About Capital Gains Distributions
Who needs to worry about mutual fund capital gains distributions? It’s easier to answer who does NOT need to worry about them, so let’s address that first.
Fortunately, if you hold an IRA, 401(k), Roth IRA, or 403(b) account, you don’t need to be concerned about capital gains distributions. These “qualified” accounts are only taxed when money is withdrawn.
Investors with trust, individual, or joint brokerage accounts, on the other hand, need to pay close attention to capital gains distributions.
In addition, if your taxable income after all deductions is estimated to fall under $42,000 filing as single or $83,000 filing as married, then your federal capital gains rate is 0%. In this case, you don’t have to worry much about federal capital gains taxes, but you should still check the impact from state capital gains taxes.
Are you an index fund investor? Then you can worry less about the tax impacts of capital gains distributions too. Index funds are passively managed and follow a broad benchmark like the S&P 500. Many index funds by companies like Vanguard, Fidelity, and Schwab often have very low or no capital gains distributions since the level of trading activity is minimal.
By the way, the capital gains distributions can be much more painful during bull market years because most of the trading activity will stack up to big capital gains by year-end.
Use Turnover to Assess Tax Impact
What’s the best way to gauge the potential capital gains tax impact? Look at the turnover metric on a fund report for insights about trading activity. According to Investopedia, mutual fund turnover “is calculated as the value of all transactions (buying, selling) divided by two, then divided by a fund's total holdings. Essentially, mutual fund turnover typically measures the replacement of holdings in a mutual fund and is commonly presented to investors as a percentage over a one-year period.”
A fund with turnover of under 10% is only exchanging or swapping 10% of its holdings in any given year. A turnover of over 50% occurs when the fund manager is trading over half of the fund holdings in a year. Index funds typically have a turnover of less than 10%. Most investors with incomes above $50,000 a year should aim to keep turnover on their funds in taxable accounts well under 50%.
Greater turnover is expected with certain types of funds, such as bonds and small cap stocks. Bonds don’t usually appreciate much, however, so they’re unlikely to be a concern from a capital gains distribution standpoint.
Keep an Eye on Actively Managed Stock Mutual Funds
So which funds do investors need to keep a pulse on when it comes to turnover rates? Actively managed mutual funds top the list. These are funds that have a manager who is purposely buying and selling winners throughout the year at a rate of over 50% turnover.
Here’s an example: A prospective client (we’ll call her Kelly) shared with me recently that her tax professional was urging her to have a mutual fund holding looked at by an investment manager.
Sure, enough, when I dug into the actual fund, there had been significant capital gains distributions over the past 3 years.
After reviewing her 2021 1099 Composite Form for her trust account, I was able to see that her mutual fund with a current value of $104,000 had paid out $35,000 in capital gains distributions. Since Kelly’s total taxable income added up to about $80,000 for the year, this $35,000 put her over the capital gains taxable threshold of $42,000 for a single filer. This added an estimated $4,600 in federal taxes to her return and likely another $1,000 in state capital gains taxes. That’s a sizeable amount of money for an individual with a total estimated income of roughly $60,000.
To top it all off, the fund with the large capital gains distributions has underperformed a standard low-cost index fund by 15% over the past 5 years. Thus, this fund not only put a drag on Kelly’s investment results, but it cost her approximately $18,000 in capital gains taxes over the past 3 years. It also probably cost additional untold amounts over the many years that the fund has been held.
How to Anticipate Capital Gains Distributions
The best way to anticipate a high capital gains distribution for a particular fund is to review your 1099s from previous years. If a given fund caused distributions last year, it’s likely to have a higher-than-average capital gains distribution in the current year.
Another way to anticipate this is to look for your fund’s turnover ratio. Any mutual fund with a ratio of more than 25% is likely to cause higher-than-average capital gains distributions.
Strategies for Minimizing Capital Gains Distributions
What can you do to minimize capital gains distributions? One of the easiest ways is to consider holding only index funds or tax-managed stock funds in your taxable accounts.
Another strategy is to hold individual stocks in your taxable accounts. In addition, you might review the capital gains distribution in the context of the overall performance. If the actively managed fund is truly outperforming the comparable benchmark by a large margin, it might be worth holding. Better yet, you’ll prevent the tax impact from the internal fund trading if you can hold this type of fund in a tax-sheltered account like an IRA or 401(k).
As you evaluate your tax situation, be aware of large outflows on a particular fund you’re holding. This information is often reported in the financial media.
You should also review your 1099 Composite Form annually with your financial advisor. Doing so will help you understand the tax implications of your current holdings. It will also allow you to strategize ways to minimize capital gains distributions in the future.
Before you begin selling high turnover funds, assess what your capital gains will be from the resulting sale. Despite the high tax due to capital gains distributions, you must use caution to prevent the other type of capital gains tax that comes from selling a fund. Conduct a careful mathematical review to learn if selling the tax-inefficient fund still makes sense.
Overall, you don’t want the tax system to prevent you from making smart investment decisions. As a Certified Public Accountant once told me, “Don’t let the tax tail wag the dog.” On the other hand, a strong understanding of investment tax impact is a prudent step for all investors.
