Hot Potato Season
It’s that time of year again, time for mutual funds to pay out their annual capital gains. Over the past decade, this hasn’t been much of an issue because many funds were able to offset gains with carried over losses from the tech stock meltdown or the 2008 credit crisis. Now, three years on, most of those carry-overs are gone and capital gains distributions are likely to be up. Many investors and unfortunately, some advisors, either don’t understand this or won’t act proactively.
When you buy a stock and it goes up, the difference between your purchase price and selling price is your taxable capital gain. To a great extent, you can control this liability by timing when and if you sell. In the meantime, it doesn’t matter how large the difference is between the purchase and potential selling price, you won’t be liable for tax on it until you actually sell it at a profit. The same is also true for mutual funds. But there’s also one other thing you can’t control and that’s the fund’s sale at a gain of stocks that it holds.
Here’s how that works: When you buy shares in an equity mutual fund, you’re actually buying an undivided interest in the fund’s portfolio. The size of your interest is proportional to the size of your investment to the overall value of the fund. Throughout the year, the fund’s manager adjusts the portfolio by buying and selling stocks in order to take advantage of profit opportunities or because of cash flows dictated by fund shareholder purchases and redemptions. Like an individual investor, the fund racks up capital gains and losses every time it trades. Also like an individual investor, the fund can offset gains with losses to eliminate or reduce taxable gains. However, unlike an individual investor, the fund must distribute its gains to its shareholders at least annually. Most funds tend to do this in the final two months of the calendar year.
One might think if a fund is down for the year, it probably won’t have any gains to distribute. One might also think if a fund is purchased one week and it distributes gains the next, there will be little or no tax liability given the short holding period. Both beliefs are dangerously wrong.
Funds that are on track to post annual losses are often brimming over in capital gains. This can happen for a number of reasons, but here’s a likely one: When the market itself suffers a sharp decline (as it did in August of this year), nervous investors flee to the safety of bonds or cash. When they sell their shares, the fund manager must sell parts of the portfolio to cover redemptions. Initially, at least, managers often try to minimize the capital gains impact by attempting to offset the sale of winners and losers. But if redemptions are too sizeable or if selling offsetting losers would result in bad investment decisions, it becomes necessary to sell appreciated holdings and realize the gains. At the end of the year the fund itself may show an annual loss, yet the remaining shareholders will get a second, negative surprise, when the fund’s taxable capital gains are distributed to them.
That’s also why the second misconception is so dangerous: It doesn’t matter how long you’ve been a shareholder in the fund, if you own it on the “record date” (usually just a week or so before the distribution), you’ll get your proportional share of the taxable gain distribution. This is like the children’s game of hot potato – whoever ends up holding it at the end gets burned. As in the example above, most of the fund’s capital gains were incurred during the year in order to pay out shareholders who are no longer in the fund at the record date. Their holdings are redeemed without the tax liability incurred to make that payment possible. Instead, shareholders as of the record date – whether long-term shareholders or simply those who invested in the fund the day before – get stuck with the taxable gains.
There is a way around this, but you must be proactive. First, most funds post information about potential gains at their websites. This includes the expected size of the distribution as well as the record date. Investors and their advisors should take note of this and not make any new fund investments until after the record date.
Existing shareholders can consider selling the fund before the record date, and investing in a similar fund or better yet, ETF, with a similar objective. If owning this particular fund is important, they can consider repurchasing it after the “wash sale” period ends (basically a month later) with no negative tax consequences. Be careful taking this approach however, because the gains realized in selling the fund may be greater than the upcoming distribution. This can easily be the case if the fund has been a long-term holding. If so, the decision should come down to which gain is less? The distribution or the shareholder’s gain?
By the way, ETFs (at least traditional ones) don’t have this problem. By their very nature, they don’t accumulate capital gains. Shares are created on purchase or destroyed at sale. Large redemptions can be paid out in kind to avoid leaving taxable gains for remaining shareholders. It’s something to keep in mind during hot potato season.
Explore posts in the same categories: Current Environment, Mutual Fund Evaluation, The Investment Decision ProcessTags: Capital Gains, Current Events, fund evaluation, mutual funds, Taxes
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