Mon, 25 Nov 2013
As equity funds have fewer losses to offset gains, investors with taxable accounts should closely monitor their holdings and brace for larger tax bills this year.
Jason Stipp: I'm Jason Stipp for Morningstar. After a multiyear market rally, fund investors may have to brace for something they haven't had to deal with for a while: fund the capital gains distributions. Here to talk about how to think about those distributions this year is Christine Benz, our director of personal finance.
Thanks for joining me, Christine.
Christine Benz: Jason, great to be here.
Stipp: Before we talk about the nitty-gritty of these capital gains distributions, what is this mechanism exactly? Why do fund investors have to deal with these?
Benz: If a mutual fund sells a holding in which it has a gain, it has to distribute those capital gains to its shareholders, and those distributions typically happen once or twice a year. For stock funds, it's usually toward the end of the year. And in practical terms, it means that mutual fund investors can pay capital gains taxes in one of two ways.
One is if they get one of these distributions, then they'll owe capital gains taxes on the distribution from the fund itself; and two if they, themselves, sell their holdings and they have a gain in the holding over the time that they've owned it, they could incur capital gains in that way, as well.
Stipp: These would apply to mutual funds you hold in taxable accounts?
Benz: That's right. So, none of this matters if you are holding a fund in a 401(k) or an IRA, the capital gains that it incurs or distributes on a year-to-year basis does not matter to you.
Stipp: And how do I know if a mutual fund is getting ready to distribute its capital gains because it hasn't happened for a lot of funds for a few years now.
Benz: That's right. In the past few years, funds had tax losses on their books from the bear market that they could use to offset their gains. Well, most funds at this point have exhausted those tax losses, so they're starting to make these distributions.
Most fund companies post a list of the estimates that they're expecting from their funds, the estimated distributions. So hop on your fund company's website and look for that link to the estimated capital gains distributions. If you can't find it for your fund or you're not online, call the fund company and ask them to provide you with the most recent estimate.
Stipp: So, you mentioned coming out of the downturn as one of the triggers here. What are some of the reasons why we are, this year especially, starting to see some these capital gains distributions, in some cases pretty big ones?
Benz: Right. I mentioned many funds have had sizable losses in the past. Many of them have burned through those losses, so they already used them to offset gains. So, at this point many funds are just paying out gains because they have had a lot more gains than they have had losses.
We tend to see some of the biggest capital gains distributions coming from funds that have also had redemptions. So they have shrinking shareholder bases. These distributions are happening across a shrinking pool of investors, and that magnifies the distribution as a percentage of net asset value. So that's one trigger. We've seen this with a couple of the American Funds; Investment Company of America is one that's poised to make a somewhat sizable payout. Calamos Growth is one that we've really been watching because this fund has had very, very large redemptions. And so it is poised to make a distribution something like 20% of its net asset value, a very sizable distribution.
Stipp: Another factor that can come into play is if a fund has seen a new manager who has made some changes to the portfolio?
Benz: That's exactly right. So, if the new manager comes in and doesn't want to hold the same portfolio that the previous manager has, he or she does some selling, and that can trigger some capital gains. One fund that's a good example of that, a fund that we liked a lot under its previous manager, T. Rowe Price New America Growth, is a fund that is expecting big capital gains distributions for this specific reason.
Stipp: Christine, if I see that my fund might be paying out a larger-than-normal capital gains distribution, what tactics should I use, if any? How should I think about this, and is there any planning I can do around it?
Benz: Sure. A lot of investors say that they want to be preemptive and maybe get out of the fund before it makes a distribution. I think you really need to be careful about that because as we talked about before, the fund shareholder can incur capital gains taxes on two levels. One is if the fund makes this distribution, which he may be trying to avoid. The second is if you sell your own shares and have a gain in the share.
Even though you may be able to avoid that capital gains distribution, you yourself may have a gain in the holding over the time period, so you won't be able to avoid capital gains altogether. In fact, you'll trigger a new type of capital gain.
Stipp: And one thing certainly you would want to do is if you're thinking of buying a fund, you probably want to check these numbers before the end of the year.
Benz: That's absolutely right. That's often called "buying the distribution." If you are looking at anything, really any equity-type fund, I would say do that checkup before you pull the trigger before year-end because there's a good chance that at least some distribution could be coming your way. And the last thing that you want to do is buy into a fund and pay taxes on a distribution that you did not enjoy in any way, shape, or form.
Taxes are back on the radar in a lot of different ways this year. This is one of them. We also saw some higher payroll taxes early in the year. There are some other taxes related to Medicare and the surcharge there. In general, what do some of these signals mean about how I should think about tax planning broadly?
Benz: I think that these capital gains distributions, specifically ought to be kind of a wake-up call to not to be lackadaisical about the types of holdings you have in your taxable account. We had been through that period where distributions were relatively benign in part because of all these great tax losses that were a silver lining of the bear market. Now that they're gone, I think it's very important to stay tuned to the tax efficiency of the holdings that you put in your taxable accounts. So that means index funds, broad market index funds, and exchange-traded funds are really great ideas for your taxable account.
Individual stocks, certainly to the extent that you hold them, give you a lot of control over capital gains realization that you don't necessarily have with some of these actively managed funds. And for people who want to hold fixed-income holdings in their taxable accounts, munis would obviously be the place to look.
Stipp: Christine, thanks for putting this very important tax issue on our radar and for those tips today.
Benz: Thank you, Jason.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.