- The key reason funds are making capital gains distributions is that we have continued to see an exodus of investors from actively managed funds.
- Some of the larger distributions this year are U.S. equity funds, although we have seen some distributions in international equity as well.
- To avoid capital gains distributions, investors can sell that fund preemptively, hang on and reinvest that distribution, or hang on but not reinvest the distribution.
Susan Dziubinski: Hi, I'm Susan Dziubinski from Morningstar. Although most stock and bond funds have lost money in 2022, many funds are still expecting to pay out capital gains to their fundholders this year. Joining me to discuss this odd disconnect and how investors can manage those distributions is Christine Benz. Christine is Morningstar's director of personal finance and retirement planning.
Christine, good to see you today.
Christine Benz: Hi, Susan. Good to see you.
Dziubinski: Let's talk about this. It's been a losing year for most funds. So, why are they making capital gains distributions?
Benz: It's incredibly frustrating. Fundholders don't necessarily have the cash on hand to pay the tax bill, and yet they're getting socked with these distributions. The key reason is that we have continued to see this exodus of investors from actively managed funds, they've borne the brunt of these redemptions. So, shareholders are leaving. Managers are having to sell things, in many cases, to raise cash to pay off departing shareholders. That selling triggers capital gains realization, and those capital gains need to be distributed to shareholders of record at the end of the year. And so, that's what we're seeing. Funds are making their distribution estimates available, but it's mainly that vicious cycle that we've seen where investors are going into passively managed funds, in part because of better tax efficiency, and they're forcing even worse tax efficiency at actively managed products.
Dziubinski: Can you generalize a little bit about maybe where we're seeing some of the larger distributions this year?
Benz: In general, it's U.S. equity funds, although we have seen some distributions in international equity as well. Large-growth funds have been seeing fairly significant outflows, in part because that category has performed fairly poorly this year after a long-running series of very strong market environments. And so, U.S. equity, and especially growth-oriented equity, appears to be bearing the brunt of the redemptions, and in turn, these funds are paying out these big capital gains distributions.
Dziubinski: Now, let's say, I owned a fund that has signaled that it's going to make a sizable capital gains payout to me. Let's talk about some of the options that I have. The first is to sell that fund pre-emptively. What should investors keep in mind if they do that?
Benz: The value of selling preemptively is that you could dodge this impending distribution. The key thing to keep your eye on, though, is to remember that you pay taxes on mutual funds in one of two ways. One, if it makes one of these distributions, either an income distribution, or in this case, a capital gains distribution. And the other tax bill could arise if you sell your own positions. So, remember that you could dodge this distribution, but if the position has appreciated since you purchased it, you will still owe taxes on that gain. Bear that in mind. Check your cost basis relative to the current share price.
I suppose a good news story in this scenario is that thanks to the combination of declining markets as well as the fact that many of these funds that are making distributions this year have been, sort of, serial distributors. This isn't the first year they've made a series of these distributions. If you've been reinvesting those distributions, you're able to increase your cost basis by the amount of that distribution. So, you've effectively prepaid your tax bill in previous years. You may find that the disconnect between the current share price and your cost basis in the security and the fund is not that great. But do your homework on your cost basis and the tax bill and whatever other implications there will be for your total tax picture. And by the way, I should have mentioned, Susan, you would want to not like this position, or you'd want to feel like it couldn't be easily replicated with something else.
Dziubinski: Christine, some people who might be thinking about selling this particular fund because they want to dodge the capital gains distribution might then be interested in repurchasing something else that's somewhat close to that. What are the tax rules around that? And then, secondly, how could someone in that situation perhaps choose an investment that's a little bit more tax-efficient so they don't end up in the same situation a few years down the road perhaps?
Benz: Really good questions. So, the first question is, if you are wanting to supplant that holding that you've just sold with something else that provides similar market exposure, you need to be aware of what's called the wash sale rule, which means that if you purchase something that the IRS considers substantially identical to the thing that you've just sold, and you do that within 30 days of the sale, you essentially disallow the tax loss. So, be careful of that substantially identical wash sale rule. That means that if you're swapping out of an index fund and into an exchange-traded fund that tracks the same market benchmark, probably not a great idea from the standpoint of the wash sale rule.
On the other hand, if you're leaving an active fund, getting into a passively managed product, that's OK. So, just keep that in mind. And then in terms of how to make that portfolio more tax-efficient on a forward-looking basis, passive products on the equity side, broad-market-tracking passive products look really good from the standpoint of tax efficiency. So, that might be traditional index funds; it might be exchange-traded funds. For higher income investors who are in a higher tax bracket, and they want to hold fixed-income securities in their portfolio, municipal bonds will be a good bet.
Dziubinski: So that covers people who want to sell in advance of the distribution. The second route that an investor could take is to just hang on and reinvest that distribution. Who is this a good situation for?
Benz: It's a good situation for the person who likes the holding, right? If you have a holding in your account, even if it's not tax-efficient, it probably makes sense to hang on, reinvest the distribution, and not sweat it so much. And remember you are getting credit for these distributions even though you're having to pay taxes in the current year in which you receive the distribution. If you're reinvesting back into the fund, you're increasing your cost basis. That reduces the taxes that will eventually be due down the line. So, it's not ideal to have a holding that's consistently kicking off a lot of capital gains. But if you like the position, it's probably the best bet to let that fundamental decision-making rather than tax factors, tax implications drive the car here.
Dziubinski: And then, lastly, there seems to be an option that sort of, I don't know, splits the difference almost in that we've covered selling, we've covered hanging on and reinvesting, but there's the third option of hanging on but not reinvesting the distribution. How might that work for someone? And who is that a good idea for?
Benz: Right. Many of us when we open up a mutual fund account, kind of, reflexively check that box saying reinvest all my income and capital gains distributions. But there is that middle ground where you can say just pay me the funds, pay me my capital gain and then you can deploy the funds into some other holding. And I think this might be particularly appropriate for people who want to start gradually moving the funds into another position. That's an easy way to do so. The funds will get deposited usually into a brokerage sweep account that's kind of living alongside your holdings. And then, you can deploy into whatever else you want, maybe some more tax-efficient fund going forward. So, that's a nice option for people who aren't quite sure and maybe aren't quite ready to make that break and pay the full tax bill that might be due upon their sale of the security.
Dziubinski: Well, Christine, thank you for your time today and for sharing these strategies. We appreciate it.
Benz: Thank you so much, Susan.
Dziubinski: I'm Susan Dziubinski with Morningstar. Thanks for tuning in.
Watch "If You Haven't Taken RMDs Yet in 2022, Watch This Video" for more from Christine Benz.