It’s that time of year when mutual funds make their capital gains distributions. As of Nov 23, the S&P 500 is up a little over 1% for the year. The Dow (DJIA) is actually fractionally down for the year. However, many mutual funds will be paying out large taxable distributions in the coming weeks.
How is this possible? It relates to the structure of mutual funds. Mutual funds aren’t taxed on their gains and losses like individual investors. Instead, the gains are passed on to investors to be taxed. The last few years (excluding 2015) have been good for the stock market. Many mutual funds are sitting on large gains in stocks they have held over the last few years. When investors sell their mutual fund shares, as happened during the recent downturn in August and September, the funds are forced to sell their holdings, generating capital gains and losses. Near the end of the year, these “gains” are distributed to investors. The funds then reinvest this phantom distribution. As an investor, you end up with the same dollar value in the fund and a tax bill!
A few examples of these large projected distributions in 2015 include American Funds Growth Fund of America (8-10% distribution), Columbia Acorn Fund (28-31% distribution), Fidelity New Millennium Fund (10-11%), and Oppenheimer Capital Appreciation Fund (13-14%). More information on mutual fund distributions can be found on CapGainsValet.
Is there anything you can do to avoid these distributions? If the shares are sold before the distribution (ex-dividend) date, you will avoid the distribution. This might make sense if your gain (or loss) in the fund is less than the capital gain distribution. One thing to be careful about is buying a mutual fund right before its distribution date. If you do this, you will have to pay taxes on the distribution, even though you may have only owned the fund for a few days. Of course, if you hold your mutual funds in a tax-deferred account like an IRA, you don’t have to worry about these distributions.
One thing to consider for the future is to own more tax-efficient investments in taxable accounts, like exchange traded funds (ETFs). Most (but not all) ETFs are able to avoid these large distributions. This allows the investor to decide when to recognize capital gains and losses, rather than forced annual distributions. Mutual funds can be held in tax-deferred accounts, like IRAs, where their annual distributions remain tax-free until funds are withdrawn from the account.
While taxes are an important factor in investing, they are not the only factor. A financial advisor can help with the many factors and decisions involved with investing.
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