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The Short Answer

Sizing Up a Fund's 'Potential' for Tax Pain

High potential capital gains exposure is sometimes, but not always, a red flag.

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Question: What is the difference between potential capital gains exposure (PCGE) and a fund company's estimated capital gain? Could I be on the hook for more taxes than the fund company is telling me?

Answer: Probably not. Most funds' fiscal years end on Oct. 31, so the capital gains estimates that fund companies publish on their websites in November and December (which are reported in per-share dollar amounts and also sometimes in more helpful percentage-of-NAV amounts) are more accurate estimates of how big a fundholder's potential tax bite will be. Capital gains distributions result when a fund manager sells an appreciated position; those gains are passed through to shareholders who must pay taxes on them if they hold the fund in a taxable account. 

By contrast, Morningstar's potential capital gains exposure data point, which is available on fund quote pages under the "Tax" tab, can give you some idea of how much of a fund's assets consist of appreciation (capital gains) that could eventually be distributed. The PCGE statistic is, therefore, an indicator of possible future capital gains distributions.

But the key word here is "possible." If the fund doesn't sell the appreciated securities, the gain will not be realized during the calendar year--or anytime soon, for that matter. For instance,  Vanguard 500 Index (VFINX) has a PCGE of around 46%. But owning this fund is not akin to holding a potential tax nightmare. Read on to find out why.

Turnover Is Key
From a tax perspective, you can think of a high positive potential capital gains estimate as sort of a worst-case scenario. The PCGE percentage measures all of the gains that have not yet been distributed to shareholders or taxed but could be in the event that the entire portfolio were turned over. 

Vanguard 500 Index tracks the S&P 500 using full replication (meaning it buys all of the stocks in the index), and because the index is market-cap weighted, the fund simply maintains the positions in the index as they grow larger and smaller. In this way, the fund portfolio self-adjusts with price moves without having to buy and sell securities in order to track the index. The S&P 500 rebalances four times per year as market caps fluctuate, and positions can enter and exit the index as a result of merger and acquisition activity and spin-offs. But it's highly unlikely that that activity would result in the portfolio turning over to any significant degree during a calendar year. Indeed, the fund's annual turnover has been around 3% for the last several years. 

One thing that could trigger capital gains payouts would be large-scale redemptions. However, the Vanguard 500 Index fund is even less likely than a traditional S&P 500 index fund to pay out capital gains distributions because of its unique share-class structure--it has both an exchange-traded fund and a mutual fund share class that feed into the same underlying fund (this share-class structure is unique to Vanguard because it's patent-protected). When there is a redemption in the ETF, Vanguard can meet the redemption using in-kind redemptions of low-cost-basis shares of stocks in the S&P 500, raising the cost basis of remaining shares in the underlying fund and helping to make it less likely (but still possible) that there will be a capital gain issuance. So, in essence, the tax implications of transactions in the ETF share class are shared with the mutual fund and vice versa. And, in fact, per Vanguard's website, the Vanguard S&P 500 Index fund is not expected to pay out any capital gains distributions this year

When Could a High Positive PCGE Be a Red Flag?
Broad market-cap-weighted index funds tend to be tax-efficient because they don't tend to turn over their portfolios frequently. But a high PCGE can be more problematic from a tax standpoint when a fund also tends to have a higher annual turnover ratio. When an event occurs that triggers higher-than-usual portfolio turnover--such as sizable asset outflows or a manager change that prompts the sale of highly appreciated securities--unrealized gains can quickly become realized.

For instance, T. Rowe Price Growth & Income (PRGIX) has a PCGE of around 51%, but its annual turnover has been pretty moderate in the last few years, and in 2014 it was around 15%. However, the fund had a manager change earlier this year, and T. Rowe Price is estimating that it will distribute about 14% of its NAV. The potential for such gains is one reason it's often advisable to use actively managed funds in a tax-sheltered account, such as an IRA or 401(k), while employing index products and ETFs in a taxable account. 

Related Reading
Morningstar director of personal finance Christine Benz has compiled a very helpful article rounding up the most notable distributions from major firms; click here to read it. You may also want to check out the following articles: 

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