Capital Gains Distributions - Wolves in Sheep's ClothingSubmitted by S. F. Ehrlich Associates, Inc. on January 14th, 2019
January 14, 2019
By: John Zeltmann
At year-end, mutual fund companies often distribute gains to shareholders in the form of capital gains distributions. Even if the fund is down for the year, shareholders may have a tax liability in their taxable accounts. These distributions are sent to investors via check, automatically deposited as cash to their brokerage account, or reinvested into the issuing mutual fund. For those investors receiving the cash distributions, many see them as welcome arrivals - year-end bonuses, if you will. But as with many things in life, it's not that simple.
Capital gains distributions – regardless of how a fund performs – are taxable distributions. While the fund may be down for the year, a shareholder would still be taxed on the gains the fund distributes. If the fund manager purchased shares of Apple 20 years ago, for example, and sold the position in the most recent year, those gains are distributed among the shareholders.
Many investors mistakenly believe that capital gains distributions are in addition to the share price of the fund. In fact, when a capital gains distribution is paid to shareholders, the price of the fund falls by the amount of the distribution per share.
In a year when the market goes down, it is counter-intuitive to lose money in a fund and then pay taxes on capital gains distributions. Depending upon your individual situation, in a down year, it may make sense to sell a mutual fund that anticipates a large distribution and purchase an exchange-traded fund that focuses on a similar segment of the market. At some point after 30 days - due to tax considerations - the exchange-traded fund could be sold and the original mutual fund repurchased.
Assume, for example, Jane Smith owns $150,000 of the DFA International Small Cap Value fund in a taxable account, and the estimated long-term capital gains distribution for that fund is 3.14%, expected to be paid on December 14th. If she holds that fund through December 14th, she would receive a long-term capital gains distribution of $4,725 paid to cash in her account. Assuming a capital gains tax rate of 15%, that's equal to a tax bill of $708.75. By selling the fund before December 14, Jane would avoid that tax bill in exchange for the cost of a few trades.
Taxes are not paid on distributions held in qualified accounts, such as an IRA, nor do losses offset capital gains. Thus, there's no benefit to engage in this strategy in those types of accounts. This strategy also would not make sense in situations where a position is so highly appreciated that any benefit from selling the fund to avoid the capital gain distribution would entirely be offset by the capital gains tax paid on the sale.
Over time, the goal of a portfolio is to grow. Growth can come in a few ways, be it through investment growth or tax savings. While we can't control which way the market moves, we might be able to control whether we strategically avoid capital gains distributions and their associated tax bills.