Investors in mutual funds may already be familiar with the ritual of end-of-year capital gains distributions. Each year in December, mutual funds would “pass through” or distribute to investors a fairly hefty chunk of cash representing profits realized on the sale of appreciated stocks and bonds.
Many investors complained, on cue, every December, resenting the tax bill to come. When a fund pays out a $1,000 gain to investors, those investors owe roughly $150 in tax the following April to the IRS.
There were years in the late 90s when big market gains made for a lot of unhappy investors, all complaining about their weighty tax bills.
Until the tech bubble that is, that is. Funny how a market crash can change your point of view, and make you look back with nostalgia on those big, bad taxable distributions of years gone by!
Fast forward to modern times. It’s been a while since mutual funds have passed through much in the way of taxable distributions. They had plenty of losses (and no gains) in 2008, and enough losses saved up on their books to offset gains from 2009 through 2012.
What is a pass through?
Now we’re in 2013, and those stored-up losses have run out. So when funds take gains by selling a holding that has gone up in value, they no longer have losses to offset them, so those gains are getting passed through to you, the investor. (Mutual funds are required by law to distribute virtually all gains to their shareholders in the form of capital gains distributions, which are then reported on Form 1099).
“The positive is, there’s been almost five years of tax-free gains, but eventually, that catches up to you,” said Russel Kinnel, director of mutual fund research at Morningstar Inc., as quoted in an interview with Investment News.
And here’s something mutual fund investors may not realize. You don’t need to sell to incur gains. Gains are incurred when the fund sells a holding at a gain, even if you have not sold any of your shares. (Note for future reference that you may also incur a gain or loss when you sell shares.)
No complaining, please
We all hate paying tax, but here’s why there’s no reason to complain about these gains. A mutual fund generates gains (or losses) by selling a stock or bond holding. This year, most funds have numerous holdings that have appreciated, or gone up, in value.
Funds sell holdings for a variety of reasons.
- It could be they’ve lost confidence in the investment going forward (think slowing sales or bad management changes).
- It could be they still like the holding, but like something else better, so need to swap one for another.
- Maybe the position has gone up in value so much that it needs to be cut back. For example, some funds don’t want an individual stock holding to exceed a certain percent of the overall fund value.
- Or maybe the fund managers think the stock has just gotten overpriced, and they want to take their profits and reinvest in something with more room to run.
I think we would agree those are all good reasons to take gains.
Holding on to a position you want to sell because you don’t want to pay the tax is foolish for funds as well as for individual investors. (Don’t believe me? Just ask any investor with over-sized bank stock holdings in their portfolio when the 2008 Great Recession hit).
Be prepared – the taxman cometh
So investors, be prepared to see hefty gains reported on your 1099 forms come January. You will probably pay tax.
The good news?
For most people, long-term capital gains are taxed at low rates, ranging from 0% to 15%. (Higher income taxpayers may pay up to 23.8% on gains).
And gains are not an issue for IRA or other retirement accounts.
More good news? Capital gains distributions are often good for your portfolio, making it easier to rebalance, or reinvest cash, in more under-valued sectors of the market.
And one final piece of good news.
We monitor your taxable accounts throughout the month of December so we can cut your tax bill. As year-end gains are distributed to you, we actively look for ways to offset gains and reduce your actual tax bill by scouring your portfolio for offsetting losses. That helps to turn investment gains back into a good thing, not something to be avoided!