Mutual Funds Capital Gains Distributions – the Good, the Bad and the Ugly
How would you like to get a December bonus of ten or 20 thousand dollars? It can happen. It happened to us.
When you get your December broker statement showing the end of year dividends and capital gains – after years of saving and investing – it can be a real treat. Typically, the amount generated from the same funds or stocks year to year is fairly consistent, but there can be exceptional years. This year was one of those years.
Big capital gains payouts can be a good thing, a bad thing or an ugly thing. But first, lets level the playing field and explain a bit about mutual fund cap gain distributions.
What are mutual fund capital gain distributions?
When you buy shares in a mutual fund, you are buying a piece of a portfolio of stocks, bonds or a mixture of both – depending on the investment goals of the fund you chose. As the year goes by, the manger of the fund may buy or sell the stocks or bonds in that portfolio.
The manager may sell because the investment goals of the fund have changed; because the manager of the fund is new and has their own ideas on the best portfolio mix or because many of the fund’s shareholders have sold their mutual fund shares, causing the manager to have to sell the underlying stocks or bonds to give the mutual fund shareholders their sale proceeds.
When the manager sells the underlying portfolio stocks or bonds, they may sell at a price over that at which they bought – creating a capital gain. Or they may sell at a loss – creating a capital loss. If the fund held the stock shares for more than a year, they create a long term capital gain (with lower tax rates than regular income), otherwise it will be a short term capital gain (taxed at regulate income rates).
If the overall losses accumulated do not exceed the overall gains, the fund is required by law to distribute the capital gains to it’s shareholders.
The shareholders then receive either cash, or have the gain reinvested in additional shares of the fund – depending on how their account is set up.
The price (net asset value) of the mutual fund shares will drop after a capital gain distribution. Here’s why. Because the fund has an outflow, the value of the total of all of the stocks and bonds and cash held in the portfolio is less. The price (net asset value) is calculated by determining the value of the total of all of the stocks, bonds and cash held in the fund’s portfolio, divided by the number of outstanding shares of the fund. Since the total value of the portfolio is less, the price of the fund drops by the amount of the distribution.
If you, as the shareholder, reinvested your capital gain in additional shares of the mutual fund, your account value will not change due to the distribution. Your shares are worth less, but you have more of them.
Are capital gains good, bad or ugly?
Most of us innately understand that getting more money from our investments is a good thing. After all, who wouldn’t want passive income? So why, when our December statement came showing all that unexpected income, was my first thought a negative one?
Capital gains can be ugly if you haven’t anticipated them for tax purposes.
Anytime you get paid, good old Uncle Sam is standing there with his hand out, demanding his share. He wants it when you get it, not just at the end of the year. If you are smart, you minimize the amount you freely give to the IRS via deductions and pay up at the end of each quarter – keeping the money in your account earning interest for you longer. That is what we do.
When I saw the large capital gain amount, I immediately thought that we may not have paid in enough estimated taxes to cover the extra income. (It turns out we did). It would have been ugly if we owed too much, perhaps involving a penalty payment.
What I neglected to do, having been lulled into receiving low capital gain distributions since 2009 due to the fact that there were so many losses that any capital gains the fund manager generated were offset (for the most part) by the losses, was to check the estimates most funds put out starting in October. In addition, I could have checked our statement via phone or online before paying the 4th quarter estimated tax in January. Either would have alerted me to the potential for added income.
So now we have the good and the ugly, why would a capital gains payout be bad?
Some investors try hard to manage the tax impact of their investments. Buying or selling a mutual fund at the wrong time can be bad for your tax strategy.
Say you are in the market for the long haul and are pulling in lots of income from your job at this point, putting you in a higher tax bracket. You have decided that you want to get out of mutual fund A and buy mutual fund B instead. If you sell fund A after it has set a ‘record date’ (the date on which any a person holding shares in the fund will receive a payout), and buy fund B after they set the record date, you will essentially get distributions from both funds and have two tax hits. As US News says in article When are capital gains distributions a bad thing:
“If you want to avoid the tax hit, you can move your money before the record date to a comparable fund not planning a large distribution. Of course, your decision might be different if the fund has lost or gained significant value”.
Do you manage your fund ownership to anticipate and avoid capital gains payouts?