It’s tax time for fund investors, even those doing nothing
NEW YORK — The end of the year can mean tax headaches for some mutual-fund investors, this year potentially more so than others.
Companies have started to warn investors of distributions they’ll make by the end of December. For anyone with a fund outside a tax-advantaged account, those payments can trigger a tax bill, even if they never sold any shares themselves.
The biggest distributions typically come from actively managed funds, which are ones that try to beat index funds. Many investors are abandoning those kinds of funds, and the departures could lead to bigger-than-usual tax bills for those shareholders that remain. So could the stock market’s record-setting performance since Election Day.
The distributions are a result of how mutual funds are set up. Each year, fund managers tally their winnings from selling stocks and bonds and then pass them onto shareholders.
Many of those distributions are worth about 5 percent of the fund’s total value. In that case, a fund that trades for $100 would pay a $5 distribution to shareholders, and its share price would drop to $95 simultaneously. Taxpayers would then be liable to pay taxes on the $5. On the higher end, those kinds of distributions can be worth more than 15 percent of a fund’s value, and the higher levels can put that much heavier a drag on returns.
“The industry focuses on pretax returns,” says Frank Pape, senior director of consulting services at Russell Investments. “But for investors, the meaningful number is the after-tax return.”
People who own mutual funds only through a 401(k), Individual Retirement Account or another tax-advantaged account don’t need to worry about gains distributions. They won’t pay a cent of taxes on them until it’s time to make a withdrawal.
But trillions of dollars in mutual funds are nevertheless held in taxable accounts. Last year, $44 of every $100 paid out in capital-gains distributions went to a taxable household account, according to the Investment Company Institute.
Investors are more likely to get hit with those distributions when the market is doing well, because that’s when managers are most likely to be selling winners. So the strong bull run for stocks since 2009 has led to a steady rise in payouts. After paying $15 billion in gains distributions during 2009, when the stock market bottomed following the Great Recession, funds paid out $400 billion five years later.
This year, the Standard & Poor’s 500 index rose 15 percent in the first 10 months. Many foreign stock markets fared even better. That makes it more likely that when fund managers made portfolio moves this year, they booked a gain that will eventually get passed along to shareholders.
The other factor pointing to big gains distributions this year is the continued exodus from actively managed funds. For years, investors have watched index funds charge lower fees and put up better returns than the majority of actively managed funds. That’s led to a tidal shift in dollars.
In the 12 months through September, investors pulled nearly $239 billion out of actively managed U.S. stock funds, according to Morningstar. With so many investors heading for the exits, managers of actively managed funds have to sell stocks and bonds to raise cash to meet the redemptions. And more sales can trigger yet more gains.
Last year, 50 percent of all stock-fund share classes made a distribution to their investors. Five years earlier, only 24 percent did so.