3 Ways to Deal With Fund Capital Gains Distributions

Mutual fund capital gain distributions fall squarely into the realm of high-class problems.

For starters, they only matter for shareholders in taxable accounts, which are generally the domain of wealthier investors. (For shareholders in tax-sheltered accounts, those distributions are a nonevent--save for a dip in the fund's net asset value that's more or less cosmetic.) And while capital gains distributions aren't perfectly aligned with shareholders' own gains--which is problematic--they are reflective of gains in a mutual fund's portfolio.

Nonetheless, the fact that funds make these gains is one of the least attractive aspects of mutual fund ownership. Unless you can identify offsetting losses in your portfolio or you land in the 0% bracket for long-term capital gains, you'll generally owe taxes on these distributions, assuming you own the fund in a taxable account. Moreover, the distributions don't necessarily coincide with your own gains in the fund. In 2020, for example, some value-leaning funds are making distributions, triggered by redemptions or manager changes, even though they're in the red for the year. Talk about adding insult to injury.

The past several years have featured a steady stream of capital gains distributions from mutual funds, owing to a few key factors: mainly, ongoing gains in the stock market and shareholder redemptions from many mutual funds in favor of exchange-traded funds, which are generally more tax-efficient than conventional mutual funds.

The question is, if your fund is among those that have announced distributions for 2020, what should you do? Conventional wisdom is that it's rarely a good idea to sell, especially during the current long-running bull market. That's because as a fund shareholder, you'll owe taxes on two sets of capital gains: the distributions that the fund itself makes, as well as on the difference between your cost basis and what your shares were worth at the time of the sale. Those two sets of gains intersect, as I'll discuss below, but they're not aligned.

But the right answer about what to do with a capital gains distribution hinges on your conviction level in the fund and your desire to continue to hold it. Here are three strategies to consider, which you can match to your interest level in remaining a shareholder.

Attitude: Firm Hold The Strategy: Reduce the Tax Hit If a fund you own is making a distribution and you're determined to hang on, the best you can do is identify ways to offset the tax pain. One way to do that, albeit an avenue that's not available to all of us, is to negate the tax hit by finding your way into the 0% bracket for long-term capital gains. In 2020, single taxpayers with incomes of less than $40,000 won't owe taxes on long-term capital gains, and married filers can have up to $80,000 in income and still fall into the 0% bracket for long-term gains. In 2020, the year of income disruptions and waived required minimum distributions, this is a realistic possibility for some.

If this isn't an option for you, you could also scout around for losing positions that you can use to offset the distribution. In years like 2019, the market lifts all boats: value and growth stocks, U.S. and foreign names, mega-caps and small fry. In such periods, it's a tall order to find losing positions in your taxable portfolio that you could sell to offset an impending capital gains distribution. But 2020 thus far has featured a two-track market, with growth stocks performing especially well even as value names, especially energy stocks, have been punished. In other words, tax-loss selling is a realistic possibility even though many funds are also making distributions. That's particularly true if you use the specific share identification method for tracking and reporting your cost basis. Under that method, you can cherry-pick specific, higher-cost lots of stocks or funds to sell that would yield a tax loss, leaving lower-cost shares (with higher tax burdens) intact.

Start by taking a close look at your cost basis for your holdings, which you can typically access via your brokerage or mutual fund company's site. Also remember the wash sale rule, which essentially negates the tax loss if you repurchase a substantially identical security within 30 days of having sold it. For example, you couldn't sell the traditional mutual fund version of Vanguard Small-Cap Value Index VSIAX and immediately purchase its ETF counterpart; those two would be considered substantially identical. Yet despite the wash sale rule, you still have a fair amount of leeway to maintain economic exposure to an area. For example, selling an actively managed small-value fund, booking the loss, and supplanting it with a small-value ETF would be perfectly allowable.

Attitude: 'Meh' The Strategy: Don't Reinvest the Distribution If you're not committed to holding a fund but selling it all would trigger a big tax bill, another strategy would be to simply not reinvest the capital gains distribution.

Of course, reinvesting distributions, both dividends and capital gains, is often a good policy; purchasing additional shares, even in small increments through reinvested distributions, is a stealth way to build wealth. Many investors, myself included, almost reflexively check the "reinvest" box when opening investment accounts.

But if a fund you own is planning a distribution and you're on the fence about holding it, one way to split the difference is to not reinvest the distribution. Instead, you could direct the capital gains payout to an investment where you have an underweight position and/or higher conviction. Assuming you hold the distributing fund in a taxable account, you'll owe taxes on the distribution regardless of whether you reinvest it or steer it into another one. Not reinvesting is also an option for dividends, and is a decent "chicken" way to rebalance.

This strategy can be a good way to reduce positions in holdings that have grown to be too large a portion of your portfolio. For example, perhaps you've long maintained a position in a technology sector fund that has grown by leaps and bounds and now occupies too large a position in your portfolio; that fund has also announced that it's about to make a capital gains distribution equal to 10% of its NAV. Selling pre-emptively would trigger a big capital gains bill, assuming you hold the position in a taxable account. But by not reinvesting your distributions, you're at least not making additional commitments to the position you don't want to grow any larger.

Attitude: Good Riddance! The Strategy: Sell Pre-Emptively Have you heard the phrase "don't let the tax tail wag the dog"? It applies here, too. If a fund that you'd like to get rid of anyway is planning to make a distribution, selling pre-emptively may indeed be the best course of action. You can upgrade the holding, and also swap into something that is likely to be more tax-efficient in the future, such as an ETF.

The good news for this strategy is that it may not cost you much in taxes, either. That's because I noticed that many of the funds making sizable distributions in 2020 are serial distributors: They made big payouts in 2018 and 2019, too. The net effect of that action, if you reinvested your distributions, is that you received a step-up in your cost basis. That means that you've effectively prepaid part of the tax bill in previous years. When you do actually sell, the spread between your cost basis and your sale price may be less than you imagine it to be.

The most common "serial distributors" today are actively managed growth-oriented funds, so if you're uncomfortable with your holdings in that area or hope to give your portfolio a tax-efficient makeover, selling may indeed make sense.