Note: This article is part of Morningstar's November 2016 Year-End Tax-Planning Guide special report. A version of this article appeared Sept. 22, 2016.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. We're coming into the fourth quarter, and that means mutual fund capital gains distribution season. Joining me to share some insights on this topic is Russ Kinnel. He is director of manager research for Morningstar.
Russ, thank you so much for being here.
Russ Kinnel: Happy to be here.
Benz: Russ, let's talk about mutual fund taxation of capital gains. It's odd and investors sometimes get socked with these unwanted capital gains. Let's talk about the logistics of this and why this happens.
Kinnel: That's right. The tax laws on mutual funds are old and a little weird. And so the basic idea though is that any capital gains or income that a fund realizes, it has to distribute to fundholders within a year, and that happens even if the fund happens to have losses overall for the year. So you can get a weird disconnect between the capital gains taxes and how the fund actually did.
Benz: And so you might receive one of these distributions at a time when you don't necessarily have the profits to cover your tax costs.
Kinnel: That's right. Sometimes you have years where a fund gained a lot and you don't pay taxes; other years, maybe the fund was flat or just barely went up and you get a big tax bill. So, there's some weird disconnects.
Benz: So, just to clarify, this doesn't affect you if you're in an IRA or a 401(k) or some sort of tax-sheltered wrapper. Only an issue within your taxable account.
Benz: So, do exchange-traded funds kind of solve for this issue, equity exchange-traded funds?
Kinnel: Well, as Ben Johnson likes to say, ETFs are tax-efficient not tax-exempt. So the same rules apply more or less, but generally there's a lot less tax issues within ETFs. Part of it is that most ETFs are index funds. So whether it's an open end or an ETF form of an index fund, you're going to have much lower turnover and therefore, generally very low tax bills. You can see that if you look at Vanguard's index funds or their ETFs. And then the second part is that the creation mechanism for ETFs is another way that washes out capital gains without requiring distributions. So ETFs have one tax advantage and then there's just the general advantage of indexing.
Benz: So, if investors are kind of setting up their taxable accounts now that maybe that's sort of a category of fund to consider.
Benz: But let's talk about some of the other types of funds, the active funds that have been making these distributions. When do we tend to see these big spikes in distributions? Are there any sort of commonalities that tend to lead funds to make sizable distributions?
Kinnel: Yeah. If you have a long-running bull market, which we have, that's usually when you see it. So, generally, it's not just how did you do this year, but how did you do over many years because it's when the capital gains are realized, not when they happen to accrue. So, in other words, if the fund had--let's say, last year a fund had huge returns but it didn't sell any of its winners, no capital gains that year. But then this year, let's say, it's flat but they sell off some of those winners that are nice profit, that's the year they are going to pay out the capital gains.
Benz: So another factor in the mix is that investors buying and selling of various funds can also contribute to capital gains realization. Let's talk about that factor.
Kinnel: Yeah. We're in a slightly unusual position in that we've had a tremendous market rally in the U.S. over the last few years, and yet a lot of active equity funds have been redeemed. So, on the one hand, they've got significant capital gains they are sitting on. On the other hand, you've got shareholders forcing them to sell. So that means you really have a significant chance for sizable capital gains this year.
Benz: So, we typically start to see these estimates of impending distributions come out in the fourth quarter. But there have actually been a few firms that have begun to release their impending distributions or their estimates of the distributions already. You flagged a couple of firms that have come out with some preliminary distribution information. One is Aston, and the Small Cap Fund in particular is forecasting a big distribution in the fourth quarter. Let's talk about that fund. What's going on there and why it is making such a big payout upward of 20% of its NAV?
Kinnel: That's right. The fund has had a manager change, and it's set for a merger. So, what's happening is the new managers are more or less culling all of the old portfolio and distributing gains to those existing shareholders prior to the merger.
Benz: American Funds is another firm that has released some early estimates and of course, things can change before it actually makes these distributions. Let's talk about a couple of the ones that jumped out at you as being not egregiously high but perhaps a little higher than one might have thought.
Kinnel: That's right. American Funds, in general, I didn't see any particular funds that jumped out and made me think, oh, no, this is a big mess or that's scary. But we did see Growth Fund of America, they are estimating between a 5% to 7% capital gains distributions. It's pretty easy to see why the fund has 15% annualized five-year return. So, significant returns, and it's had some significant redemptions along that five-year period, so not too surprising. Also, Washington Mutual is expecting to distribute about 4% to 6% in capital gains. So really these are fairly typical for what you'd see, but worth noting anyway, worth thinking about for your tax planning.
Benz: I guess that's a question though. Investors sometimes might think, well, if there's big distributions coming and maybe I wanted to lighten up on this holding anyway, should I sell pre-emptively? What do you think of that strategy?
Kinnel: Well, generally it doesn't work too well because you probably have built up some significant gains yourself.
Benz: You've participated in this rally too.
Kinnel: That's right. So back to Growth Fund of America, if you've owned it five years ago to today you've gained a lot as well. But there are some certain circumstances where maybe it's a good idea. I think you want to check with accountant and really do the math, check with the fund company which should be able to tell you your cost basis.
Benz: Right. Yeah, I think that's one thing that investors maybe don't recognize so much is that it's not like you will necessarily pay taxes on these gains twice, that you do get your cost basis stepped up when you receive one of these distributions and that affects that taxes you owe when you sell.
Kinnel: That's right. So mostly what you're doing is really picking when you pay those taxes. It's not so much about completely avoiding them.
Benz: OK. Russ, complicated topic. Thank you so much for being here to discuss it with us.
Kinnel: You're welcome.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.