A Surprise Tax Bill From Your Mutual Fund Positions
Asset allocation can be the single most important factor in determining long-term investment returns, but asset location is a close second. How do you decide where to put certain investments, and in which investment vehicles should you place them? How will any particular investment choice affect your current and future tax situation? The two primary investment vehicles we use for clients are mutual funds and exchange-traded funds (ETFs). These are simply two different legal entities that hold a diversified array of investments, but they have a few distinct differences. The main contrast is intraday price transparency with ETFs, which are priced similarly to equities. As the underlying investments fluctuate in value, so does the ETF price. Mutual funds are only priced once daily, after market close. The fund administrator calculates the value of the investments, takes out any fees, and arrives at a price called net asset value.
Capital Gains—A Benefit, But a Drag on Returns
A key difference that may impact your investment return significantly is the tax treatment of these entities. When redemptions are made from a mutual fund, the manager of the fund must accommodate the demand for cash by liquidating positions it holds. Selling out of a position that has increased in value will trigger a realized gain, similar to an individual investor making a sale. The gain is recognized, and subsequently taxed, by the investors who are still in the fund at the end of the year in which those capital gains are distributed. Capital gains are normally a good thing when you sell a successful investment. Being taxed on a capital gain you have not received directly is less appealing.
This tax treatment can be particularly frustrating when the mutual fund posts negative investment performance in a calendar year. Think back to 2017—the market skyrocketed to new highs after the better part of a decade moving upward. The following year was more tumultuous, with most equity funds closing their books at a loss. Many investors redeemed their shares throughout the course of the year, chasing returns elsewhere or leaving their savings in cash. Increased redemptions caused mutual fund managers to sell appreciated holdings, leaving the remaining investor base to pay the tax bill. Those left in the fund actually paid a larger percentage of the capital gains tax because there were less investors to share the burden. Distributions from any fund will be taxable whether they are reinvested into the fund or used for spending. This means you could have ended the year at a loss, reinvested more into the fund, and still paid taxes on your investment.
Here is a look at total mutual fund capital gains distributions by year, starting in 2000.
Total Capital Gains Paid by Calendar Year
Source: Investment Company Institute
The combination of appreciated assets and redemptions by investors caused historically high rates of distributions in 2018. What does this mean for 2020?
U.S. Open Ended Mutual Fund & EFT Net Cash Flows (Jan 2007 – June 2020)
Source: Russell Investments
Several of the same factors that caused the distributions in 2018 are also occurring in 2020. The S&P 500 ended 2019 with a return of almost 29 percent. Many U.S. equity funds should have had significant unrealized gains going into 2020. March 2020, along with the market lows from COVID, saw many investors moving into cash, just to miss out on the massive return to new heights in Q3. Investors holding mutual fund positions in taxable accounts should be prepared to receive some level of distribution each year. Planning for these distributions can influence your after-tax returns.
What are your options to minimize the taxes you pay from mutual fund capital gain distributions?
1) Consider shifting to a more tax-efficient portfolio.
Any taxable accounts should consider holding index-based mutual funds and ETFs. The managers of these portfolios tend to hold on to their investments for a longer time horizon and sell positions less frequently. This leads to greater tax efficiency in the accounts. If you hold funds that have a high turnover of their investments, your retirement accounts are a great vehicle to shelter taxable distributions.
Morningstar tracks yearly distribution rates for mutual funds across asset classes. Its data shows that passively traded mutual funds have lower distributions on average. However, even passive mutual funds cannot avoid the consequences of more distributions when investors rush to redeem their shares. The outcome of this can be seen in the 2018 column of the charts below.
Passive Mutual Funds—Average Capital Gains Distribution/Net Asset Value (%)
Active Mutual Funds—Average Capital Gains Distributions/Net Asset Value (%)
2) Use tax-loss harvesting to offset gains from distributions with losses from other positions.
Your advisor at CPWM will work with you to find out which positions you can strategically sell to offset potential capital gain distributions at the end of the year.
3) Balance the cost of liquidating now versus in the future.
Capital gains tax rates are historically low right now, so it may be a good option to take some of these positions off the table, if your current asset allocation warrants rebalancing. There may be an opportunity to sell these positions in a year in which your income may be lower and taxed at a lower rate.
4) Change your reinvestment options.
Reinvesting capital gains distributions causes your basis in the position to increase. If you plan on selling the position at some point, this means your realized gain could be lower, meaning less taxable income attributed to that sale. On the other hand, you are putting your future tax situation in auto-drive by automatically reinvesting. More cash will be placed into these funds, until you are stuck with such a high unrealized gain that liquidation would cause too large of a taxable event. Regardless of whether you reinvest or not, you are still required to pay taxes on the capital gains distributions.
5) Consider gifting appreciated positions to charity.
Donor-advised funds (DAFs) facilitate the gifting of investments or cash to a charity of your choice. There may be an opportunity to gift long-term appreciated assets such as mutual funds to a DAF. This could in turn lower your cost basis and provide for a deduction from your adjusted gross income.
At CPWM, we monitor upcoming capital gains distributions closely. Most mutual fund providers will post estimates toward the end of the year regarding when the distributions will happen, and an estimate of the percentage of NAV that will be distributed. We use this information to determine the magnitude of distributions which our clients may be susceptible to. If you have questions, don’t hesitate to reach out.
– Investment Company Institute. 2020. “Worldwide Regulated Open-End Fund Assets and Flows Second Quarter 2020” (September). For the most up-to-date figures about the fund industry, please visit www.ici.org/research/stats.
– Pape, Frank. “Capital Gains 2020 Outlook: Russell Investments.” Capital Gains 2020 Outlook | Russell Investments, 2020, russellinvestments.com/us/blog/open-season-capital-gains.
– Johnson, Ben, and Alex Bryan. Morningstar, 2019, pp. 1–29, Measuring ETFs’ Tax Efficiency Versus Mutual Funds.
Important Disclosure Information:
Different types of investments involve varying degrees of risk, including the risk of loss of your entire investment. Past performance is not indicative of future results. CPWM and its employees can give no assurance that the performance of any specific investment recommendation or investment strategy discussed herein, whether directly or indirectly, will be profitable, or that it will be equal to any historical performance level discussed herein. The discussion or information contained herein is not intended to be, and should not be deemed as, personalized investment advice. The recommendations made may not be suitable for your specific individual situation and we encourage you to discuss with your financial professional before undertaking any investment strategy or recommendation contained herein. The discussions contained in this blog is current only as of the date hereof and may change due to a number of factors, including varying market conditions.