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Investing Specialists

Don't Put Up With Big Capital Gains Payouts

Taxable investors: There is a better way.

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I wrote about mutual funds' impending capital gains payouts last week. Some of these distributions are sizable, amounting to more than 10% of the funds' net asset values. Despite the impending tax pain, many investors seemed to greet the news with a shrug. Big capital gains distributions? Just a part of making money.

But investors who take big capital gains distributions lying down are leaving money on the table. With proper asset location, and more importantly, careful investment selection for your taxable accounts, you can reduce unwanted capital gains distributions to a trickle. Yes, you'll still owe capital gains taxes when you finally sell those appreciated securities from your taxable account. But the crucial difference is that you'll exert control over when you'll owe those taxes, and the taxes you pay will be tied directly to your own profits.

Two Kinds of Distributions
To review, investors in mutual funds can owe capital gains taxes for two reasons. The first, and most obvious, reason is if they sell a fund and they've made a profit over their holding period. If an investor in the 25% income tax bracket sells a fund position that has appreciated from $10,000 to $30,000 since its purchase three years ago, he or she would owe $3,000 in capital gains taxes--the $20,000 in appreciation times the 15% capital gains tax. (People in the 15% income tax bracket and below pay 0% on long-term capital gains; those in the 25% to 35% brackets for ordinary income pay a 15% long-term capital gains rate; and taxpayers in the 39.6% tax bracket for ordinary income pay a 20% rate on long-term capital gains.)

But investors can also owe taxes when they haven't sold a share. If funds themselves sell appreciated securities, they're required to pass on those gains to shareholders, who in turn must pay taxes on those gains. For example, let's say a fund sells all of its shares in a stock; its original position size was $1 million, but the position had appreciated to a $5 million position at the time of sale four years later. The fund has a $4 million gain that it must distribute to all of its shareholders in the year of the sale, assuming management has no offsetting losses elsewhere in the portfolio. (Funds can engage in tax-loss selling, just as individuals can.) And shareholders, in turn, will owe taxes on those distributions.

One of These Things Is Not Like (and Better Than) The Other
Control is the key reason why paying the former type of capital gains is preferable to paying the latter type. If you don't sell any of your securities, you won't trigger a capital gains tax bill. You can delay selling the securities until it makes sense for you to do so--when you are in a low tax year, for example, or when you've decided to cut the cord for investment reasons.

Capital gains that you realize due to your own selling are also directly aligned with your own gain in the security; the taxes you pay depend on your own profit. Most of us would agree that's the fair way for it to work.

Both of those positive attributes can be missing when it comes to mutual fund capital gains distributions, however. For one thing, the fund shareholder doesn't exert any control over when the gains are realized; whether or not a fund pays out a distribution depends on a mosh pit of factors, from how the fund's investment style has performed to the fund's turnover rate to whether the fund has had a manager change or redemptions. Not only is it difficult to forecast whether a fund will make a big payout, it's also difficult to avoid mutual fund capital gains distributions. The investor's only avenue is to pre-emptively sell a fund before it makes a distribution, but that's usually not a good route to take because the sale of a highly appreciated fund could trigger its own tax bill.

And in contrast to capital gains taxes due on an investor's own sale, the taxes you'll owe on mutual fund capital gains distributions aren't necessarily aligned with the investor's own profits. An investor who's newly arrived in a fund can "buy the distribution"--that is, make a purchase just in time to receive the capital gains distribution, having never been around to enjoy the profits that preceded it.

A Better Way
The good news is that it's easier than ever to remedy unwanted capital gains distributions. The recent round of mutual fund distributions--as well as waves of large distributions in years past--strongly suggests that actively managed funds aren't a great fit within taxable accounts. Even if you go out of your way to identify active funds that won't be doing a lot of trading--and are, therefore, unlikely to make big capital gains distributions--events could transpire to trigger a payout. A fund could undergo a manager change, for example, and the change-over could prompt selling of some of the fund's long-held positions. Alternatively, the low-turnover fund could see redemptions if its performance weakens. Not only might management have to sell long-held positions to pay off departing shareholders, thereby triggering capital gains distributions, but those distributions would be dispersed across a shrunken base of shareholders.

Instead, investors should focus the equity exposure in their taxable accounts on the subset of investments that a) give them more control over capital gains realization and b) allow them to align their tax burden with their profits. On the short list would be individual stocks, exchange-traded funds, broad-market index funds, and tax-managed funds. Buying and holding individual stocks gives the investor maximum control over capital gains realization, of course. Meanwhile, index funds and ETFs aren't foolproof ways to reduce unwanted distributions, as Robert Goldsborough discusses in this rundown of 2014 ETF capital gains distributions. Both equity ETFs and index funds can make distributions if their underlying indexes are reshuffled, for example. But carefully chosen, broad-market equity ETFs and index funds can do a good job of limiting capital gains distributions.

A pair of Vanguard funds nicely illustrates the merits of paying attention to tax matters when deciding which types of assets go where.  Vanguard Mid Cap Growth (VMGRX) and  Vanguard Mid-Cap Growth Index (VMGIX) both have much to recommend them. The former is a Bronze-rated, actively managed fund and the latter is a Silver-rated index fund. The two funds' five-year returns through the end of November were also quite similar: 18.02% for the active fund versus 18.22% to the index fund.

But the answer about which to hold in a taxable account is an easy one. The active fund's five-year post-tax return (factoring in dividend and short- and long-term capital gains distributions) is 16.99%, versus 18.03% for the index fund. Moreover, the actively managed fund is on track to make one of the largest capital gains distributions in the Vanguard stable. Its tax-cost ratio, which factors in its minimal dividends as well as capital gains payouts, ranges from 2.84% over the past year to 1.14% over the past 15 years. The fund's relatively poor tax efficiency, especially recently, owes to the combination of strong appreciation in some of its holdings and a turnover rate of more than 80%.

That's not to suggest that actively managed funds are inferior in every instance. But until Congress fixes the capital gains treatment of mutual funds so that the taxes investors owe are more closely aligned with their own profits, actively managed equity funds are a tough sell in taxable accounts.

See More Articles by Christine Benz

Christine Benz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.