Cap­i­tal gain dis­tri­bu­tions are com­ing

Chattanooga Times Free Press - - BUSINESS -

If you own open-end mu­tual fund shares out­side your IRA or other taxde­ferred ac­counts, be on the look­out for the tax man. It’s that time of year again, when funds make re­quired dis­tri­bu­tions of re­al­ized cap­i­tal gains to share­hold­ers, who must in turn re­port these gains to Un­cle Sam. This an­nual rite is of­ten mis­un­der­stood, but is an im­por­tant con­sid­er­a­tion in man­ag­ing your in­vest­ment port­fo­lio.

When you buy an in­di­vid­ual stock, your ul­ti­mate cap­i­tal gain or loss is de­ter­mined at the time of sale. This al­lows you to con­trol the tim­ing of any tax bill that may arise from the ap­pre­ci­a­tion in your in­vest­ment. Mu­tual funds are treated some­what dif­fer­ently ow­ing to the fact they con­sist of mul­ti­ple in­vest­ments, some of which may be sold through­out the year. If the net­ting of all sales dur­ing the year re­sults in a cap­i­tal gain, the bulk of that gain must be paid out to fund share­hold­ers, even if the hold­ers do not sell any of their shares. This can some­times come as an un­pleas­ant sur­prise.

Mu­tual fund com­pa­nies gen­er­ally make ev­ery ef­fort to min­i­mize tax li­a­bil­ity to their in­vestors. But there are times dur­ing which the funds must sell hold­ings to raise cash, es­pe­cially if there are sig­nif­i­cant re­demp­tion re­quests from hold­ers want­ing some or all of their money. The fund man­ager will of­ten be forced to sell po­si­tions with em­bed­ded cap­i­tal gains in order to raise cash, and it is these re­al­ized gains that must be passed along to share­hold­ers.

Ex­change traded funds or ETFs have arisen as a sig­nif­i­cant chal­lenger to tra­di­tional mu­tual funds, par­tic­u­larly in the pas­sive in­dex space, in part be­cause of their rel­a­tive tax ef­fi­ciency. Ow­ing to the dif­fer­ence in how ETF shares are con­structed, in­dex ETFs rarely pay out cap­i­tal gains dis­tri­bu­tions, al­low­ing in­vestors to bet­ter con­trol the tim­ing of their tax obli­ga­tions much like our pre­vi­ous ex­am­ple of in­di­vid­ual stock hold­ings.

Cap­i­tal gain dis­tri­bu­tions also come in two fla­vors. Longterm gains arise from po­si­tions held by the fund for more than one year. These dis­tri­bu­tions are taxed at the same long-term gain rates as for in­di­vid­ual stocks, cur­rently 15 per­cent for most tax­pay­ers. Short-term gains, which are less com­mon, re­sult from sales of in­vest­ments held less than a year, and are gen­er­ally sub­ject to or­di­nary in­come tax rates.

Mu­tual fund com­pa­nies typ­i­cally pub­lish a list of es­ti­mated dis­tri­bu­tion dates and amounts on their web­sites. De­pend­ing upon the mag­ni­tude of po­ten­tial obli­ga­tions, in­vestors have the op­por­tu­nity to plan for pro­jected li­a­bil­i­ties by re­al­iz­ing losses else­where or even sell­ing some of the fund shares in ad­vance of the pay­out. How­ever, a sale may in­cur ad­di­tional tax­able gains that over­whelm the ex­pected dis­tri­bu­tions, so it is usu­ally not an op­ti­mal strat­egy.

There is a bright side. The re­ported tax­able dis­tri­bu­tion can usu­ally be rein­vested back in the fund. This al­lows you to in­cre­men­tally in­crease the cost ba­sis in your over­all po­si­tion, re­duc­ing fu­ture tax li­a­bil­ity.

Es­ti­mated gain dis­tri­bu­tions are par­tic­u­larly im­por­tant for in­vestors con­sid­er­ing a new pur­chase of a mu­tual fund. Be care­ful in mak­ing your pur­chase be­fore the year-end dis­tri­bu­tions (gen­er­ally late Novem­ber to mid-De­cem­ber). You could find your­self pay­ing taxes on cap­i­tal gains in which you did not par­tic­i­pate. Think about hold­ing off un­til af­ter the dis­tri­bu­tion be­fore buy­ing in.

Cer­tain funds have a greater propen­sity to pay gains, es­pe­cially high-turnover funds with lots of trans­ac­tions. Tax ef­fi­ciency and low turnover are im­por­tant con­sid­er­a­tions in tax­able ac­counts, all else equal.

Mu­tual funds have been tremen­dous tools for in­di­vid­ual in­vestors, but they come with their own unique caveats for tax­able in­vestors.

Christo­pher A. Hop­kins, CFA, is a vice pres­i­dent and port­fo­lio man­ager for Bar­nett & Co. in Chat­tanooga

Christo­pher A. Hop­kins

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