It's Not Too Early to Plan for Mutual Fund Capital Gain Distributions

Davis NY Venture recently made one, and Sequoia did, too.

I'm talking about capital gains distributions, and they're just not for year end. Some funds distribute to shareholders earlier in the year, perhaps to stave off shareholders who might otherwise be inclined to jump ship pre-emptively before a distribution later in the year. Columbia Funds, for example, made a slew of distributions in early June.

Whether distributions occur midyear or at the usual time--year end--2018 is likely to be yet another in a string of lousy years for mutual funds capital gains distributions. That's because the same key factors that have led to distributions over the past five-plus years are in place today: namely, decent equity-market performance as well as ongoing shareholder redemptions from funds.

Given that backdrop, it pays to be careful when deciding what types of investments to hold in your taxable (nonretirement accounts). And if you already own funds that could be poised to make distributions later this year, it's worthwhile to formulate a strategy for dealing with them. Will you sell pre-emptively or sit tight?

Capital Gains Unpacked Before we go any further, let's quickly review the rules related to capital gains taxation for mutual fund investors. A crucial point is that capital gains distributions don't matter at all to you if all of your investments are in a tax-sheltered retirement savings vehicle. In that case, you can buy and sell securities all day long and still not face a tax bill as long as the money stays inside the tax-sheltered account. You only have to pay taxes on those assets when you begin pulling money out in retirement. (If you've made Roth contributions you won't even have to do that!)

Capital gains taxes only come into play if you have assets in a nonretirement account like a brokerage account. In that case, you can be taxed in one of two ways. The first way is the same as with any other security: If you sell your fund, you'll be liable for capital gains tax on any appreciation in it over your holding period. If you sell out in one year or less, short-term capital gains tax applies; if you sell out after holding the security for more than a year, you're eligible for lower long-term capital gains rates. And as with any other security, you're also liable for taxes on any income or dividend income that you receive as a shareholder. All of those distributions are subject to tax regardless of whether you spend them or reinvest them back into the fund.

The second way you can be taxed--and this is specific to mutual fund shareholders--is if your fund makes a capital gain distributions over your holding period. Funds distribute capital gains if they've sold appreciated securities and realized a gain; if you're a shareholder of record at the time of that distribution, you're liable for any taxes due on that distribution. In contrast with the distributions outlined above, those distributions wouldn't necessarily align with your personal gains or losses; you could have purchased the fund last week or have a loss over your holding period but still get socked with a distribution. You will also owe capital gains tax on such a distribution, whether you take the money and spend it or you're reinvesting those distributions back into the fund. (The one exception is if you're in the zero percent long-term capital gains bracket, meaning that you're a single filer with income below $38,600 or a joint filer with income below $77,200.)

Another Big Year, and Not in a Good Way As mentioned above, the combination of strong market returns and shareholder redemptions from mutual funds have contributed to several years' worth of sizable capital gains distributions. Upward-trending markets for nearly a decade mean that many equity-fund portfolios are stuffed with securities that have appreciated since purchase. Shareholder redemptions often force fund managers to unload those appreciated positions to raise cash to pay off departing shareholders, thereby triggering capital gain distributions. To add insult to injury, those distributions get distributed across a smaller shareholder base if the fund has shrunk in size.

Active U.S. equity funds have been the biggest capital gain distributors in recent years. Yet passive U.S. equity funds have recently seen outflows, thanks largely to concentrated selling at a handful of funds. The selling pressure is relatively new, however, and index products, especially ETFs, tend to be among the most tax-efficient products around. That means that big capital gains distributions are likely to continue to come from actively managed U.S. equity funds in 2018, not index funds or ETFs.

International-equity funds had been seeing inflows (at least until recently) and returns have generally not been as robust as U.S. funds, so capital gains have been less of an issue for foreign-fund investors. Bond funds, meanwhile, pay out most of their returns in the form of ongoing income distributions, so capital-gain distributions don't typically affect them much.

What You Can Do Fund companies typically begin releasing estimates of their expected capital gains distributions in the fourth quarter of each year, depicting expected distributions in dollar terms or as a percentage of the fund's net asset value. If you see the estimated distribution in dollars, you'll need to divide that number by the fund's current NAV to determine whether the distribution is anything to be excited about. Distributions of 2% to 3% of NAV won't likely have a big impact on your tax bill (unless, of course, you have a very large position), whereas those edging close to the 10% range are obviously more impactful.

You may also be able to sniff out capital gains distributions pre-emptively. If your fund's asset base has been shrinking dramatically but has generated strong returns, that can be a signal that a capital gains distribution is on the way. And just because a fund has made distributions in the previous few years, don't assume the worst is over: If investors have continued to sell and/or stocks have hit management's price targets for them, additional capital gains distributions could be in the offing.

The big question is, what should you do if you expect a large distribution? At first blush, you might be tempted to sell pre-emptively to avoid the distribution. But remember that you can be taxed in two ways as a fund shareholder--on the fund's distributions as well as your own selling. Thus, by selling pre-emptively, you'd dodge the fund's distribution but could also trigger your own tax bill on the appreciation since you made your purchase.

That said, if you own a fund that has been a serial distributor of capital gains that you've reinvested back into the fund, selling might not unleash that big of a tax bill after all. That's because you're able to "step up" or increase your cost basis to account for any reinvested dividends or capital gains, as discussed here. That step-up is meant to account for the fact that you've been paying the taxes on those distributions you've already received, so any taxes due on your eventual sale should factor in the taxes you've effectively prepaid.

The net effect of that accounting is that selling out of a serial capital gains distributor may cost you less in taxes than you imagined. For a quick and dirty view of the taxes due upon the sale of your shares, compare your cost basis (which you should be able to find on your fund company's website) with the current value of your shares. If those two amounts are close together, that means that your tax bill is apt to be pretty modest, too. In other words, giving your portfolio a tax-efficient makeover may be less costly than you think.

That said, if you've been dollar-cost averaging into your position and have purchased shares recently, be aware that selling those shares could trigger a short-term capital gain, which is taxed at your ordinary income tax rate. That might seem small in the scheme of things, but it's something to keep in mind before making changes.