By Debbie Carlson
Amid the holiday cards coming in the mail and inboxes this season is a potentially not-so-nice greeting for some mutual-fund investors: capital-gains distributions.
It’s not all bad news. A number of funds are paying out gains because stocks gained this year, with the S&P 500 index /zigman2/quotes/210599714/realtime SPX +1.97% up 22% through November (and has continued rising in December). International markets also performed well, with the MSCI ACWI index /zigman2/quotes/208607471/composite ACWI +2.05% up 16.8% in the same 11 months.
But the lump-of-coal part is a possible tax bill.
Mutual-fund investors with holdings in taxable accounts need to prepare for a tax hit on distributed gains — even if they reinvest the distributions. They can offset some or all of the gains (and taxes) if they’ve sold positions at a loss.
People who own mutual funds in tax-sheltered accounts such as 401(k)s or individual retirement accounts and are reinvesting the distributions, on the other hand, don’t have to worry. In those accounts, taxes only count when investors sell holdings in retirement, and those who have funds in qualified Roth IRAs won’t have to pay even then.
Fund companies generally estimate their distributions based on share prices between the end of September or October. This information is found on the fund company’s website, usually under information about taxes. Payouts are described in percentages of assets, based on share prices at the time of the estimate.
Mutual funds vs. ETFs
There’s a second big reason beyond a great year for stocks that explains why fund companies overall are paying out capital gains: the trend of investors moving assets out of mutual funds and into exchange-traded funds, said Christopher Franz, associate director of equity strategies, at Morningstar.
For the past several years, mutual-fund companies have seen their assets flow out on speed skates and into exchange-traded funds, in large part because of lower fees and tax efficiency. In many cases, actively managed funds are losing money to mostly passively managed ETFs.
Because of how mutual funds are structured, when investors sell their mutual-fund holdings, the portfolio managers need to sell assets to pay those redemptions. Unless they can offset those gains with losses, the managers book those gains and pass them on to shareholders.
ETFs are tax-efficient because the creation/redemption process mitigates some of these capital-gains distributions. There are rare times when ETFs pass on capital gains.
This mutual fund structure explains why investors who own mutual funds in taxable accounts get hit with capital-gains distributions even if they didn’t sell a single share, a very Grinch-like outcome.
“It’s just a brutal reminder that within the mutual fund structure … it essentially socializes the cost of doing business,” Franz said.
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Distributions are larger than in the past
Morningstar annually spot checks capital-gains distribution rates for about two dozen of the major fund families, and Franz said this year’s trend is pretty typical to last year. The firm doesn’t have any broad average numbers on the average payout or percentage size of distribution because the data set is too wide, but anecdotally the firm notes distributions are bigger now than what they were historically. The combination of redemptions and strong stock market gains are increasing payout sizes, he said.
There can be specific reasons for why a fund has a high payout, such as changes in managers, strategies or indexes.
For the past few years, growth funds investors have contended with sizable distributions because of market gains, but this year distributions are spread more widely, Franz said, including in some value-oriented strategies. Value strategies have typically lagged the broader market recently, but this year value saw a rebound.