Year-end is a natural time for investors to review their portfolio’s performance.

And while it’s a good idea to check in on your portfolio, it is a crucial mistake for mutual fund shareholders to ignore the potential tax impact of year-end capital gains distributions. Returns without an awareness of the tax implications can be problematic on a number of fronts.

What are mutual funds and why do they pay out capital gains distributions?

A mutual fund is an investment vehicle that pools together monies from multiple shareholders to purchase securities, typically stocks or bonds. Shareholders receive benefits such as diversification, as the fund will hold many securities for which it would be unrealistic for an individual to conduct due diligence on, professional expertise, provided by the fund’s managers, and technological resources, leveraged by the fund’s technicians. Shareholders also benefit by having a team of analysts reviewing and rebalancing their portfolio, in order to keep the fund in line with its stated goals, and from the liquidity which mutual funds afford.

Throughout the year, mutual funds will make buys and sells to ensure that their strategy remains in line with their stated objectives, and to take advantage of any market dislocations. Depending on how long these assets were held by the mutual fund, profitable trades may fall into one of two taxable categories, short-term and long-term capital gains. Short-term is applicable for investments held for less than one year, and is generally taxed as ordinary income, while long-term applies to positions held for longer than one year, and is taxed at the long-term capital gains rate. Mutual funds are mandated by law to distribute at least 98% of their net capital gains (after “netting” out trades with losses and gains) to shareholders once per year; typically, mutual fund distributions are paid out in November or December. The distribution that you receive will be dispersed automatically by the mutual fund, and may consist of both short-term and long-term capital gains. Because mutual funds may execute hundreds or thousands of trades each year, estimating your resulting tax liability can be quite challenging, but failure to do so can leave you susceptible to significantly underestimating what you owe in April, and can even result in moving you into another tax bracket.

Mutual funds are a practical part of my investment allocation and I am sensitive to paying more than I should in income taxes; how should I navigate capital gains distributions?

First, consider the location of the mutual fund holding.  If the fund is held within a qualified account, such as an IRA, there would be no income tax bill from a distribution. Within a taxable account (such as a trust, or a joint or individually held investment account), an investor should avoid buying the fund prior to the distribution date. It is also important to weigh the difference in taxes between selling the fund prior to the distribution date or holding onto the fund and taking the distribution.

Mutual funds typically post estimates for year-end capital gain distributions and pay out dates in November or December. The extent to which your advisor monitors these distributions can vary considerably – ranging from an investment advisor, who may execute your trades dutifully, but leave all of the planning elements to you, to a wealth management firm who may monitor and evaluate distributions, but only those they deem significant. Our Investment Management process includes evaluating all mutual fund distributions, no matter the size.  And for each client we serve, we monitor, review and estimate the tax implications from all such distributions. This allows us to make investment trades throughout the year to minimize the tax bill, and to more efficiently rebalance and align each client’s portfolio to support their unique goals.

In 2016, U.S. stock mutual funds paid out nearly $200 billion in capital gains distributions, according to the Investment Company Institute.  By our measurements, 2017 capital gains distributions will be nearly as significant, driven in part by recent stock market appreciation.  Without properly estimating the tax implications, mutual fund distributions can represent lost opportunities to offset losses or execute carryforwards, and in some circumstances, can leave an investor wide open for headaches come April.

In our opinion, year-end is an occasion best spent with family. And as a matter of course, we monitor the tax implications of capital gains distributions for each of our clients, to simplify the complexities of their wealth, and to give them back the most precious commodity of all: time.

If you have any questions about our tax planning or investment management process, click here to reach out to our team.

Chase D. Conti, CFP®

Senior Investment Analyst

Hall of