- If a mutual fund has a holding that has appreciated and goes on to sell it, the fund realizes a capital gain on that position, and those gains in turn need to get passed on to shareholders by the end of each year, which is why we typically see this rush of funds making distributions in the November/December period.
- If a fund that you own makes a distribution, you can increase your cost basis to account for the fact that you’ve received this distribution. It essentially ensures that you don’t pay taxes twice on that distribution when you eventually sell the position.
- We’ve had several years in a row with funds making pretty sizable distributions. This is because we’ve had a fairly robust stock market for several years running.
- Anything over 10% of net asset value is a sizable distribution.
- One strategy for investors who own a fund that is going to make a capital gains distribution is to just sit tight and reinvest that distribution.
Susan Dziubinski: Hi, I’m Susan Dziubinski with Morningstar. Fund companies have begun releasing estimates of the capital gains distributions they expect to pay out to fundholders before year-end. Joining me to discuss some strategies investors can use to manage those distributions is Christine Benz. She’s Morningstar’s director of personal finance and retirement planning. Great to see you, Christine.
Christine Benz: Hi, Susan. Always great to see you.
Why Do Funds Make Capital Gains Distributions?
Dziubinski: Before we start delving into some of these specific strategies that investors can use to sort of help mitigate that tax hit, let’s discuss why funds make capital gains distributions in the first place.
Benz: Sure. If a mutual fund has a holding that has appreciated, and they go on to sell it, they realize a capital gain on that position, and those gains in turn need to get passed on to shareholders by the end of each year, which is why we typically see this rush of funds making distributions in the November/December period each year.
Taxes and Capital Gains Distributions
Dziubinski: There are no immediate tax implications to someone who’s holding a fund that makes a distribution in a tax-deferred account. No immediate tax ramifications there. But how do taxes work for investors who receive these capital gains distributions from funds that they’re holding in taxable accounts?
Benz: Right. This matters if you hold a fund in a taxable brokerage account because if a fund makes a distribution, you will pay taxes on that distribution regardless of whether you’re reinvesting it right back into the fund. And so I think as a shareholder of a fund, it’s important to remember that you have two sets of ledgers that determine your tax liability associated with a fund. One would be if the fund itself makes these income or capital gains distributions. And also when you sell, you may also owe a capital gain when you sell your own position. It’s important to bear that in mind. Those two things kind of work together. If a fund that you own makes a distribution, you are able to increase your cost basis to account for the fact that you’ve received this distribution. It essentially ensures that you don’t pay taxes twice on that distribution when you eventually sell the position.
Capital Gains Distributions in 2023
Dziubinski: Got it. We’ve had several years in a row now where we’ve seen funds making some really pretty sizable distributions. Why is this happening and do you have a read yet on how 2023′s capital gains distributions are looking relative to prior years?
Benz: So, very big picture: The reason it’s happening is that we’ve had a fairly robust stock market for several years running. So that’s the major overhang. But there’s also something going on with fund flows in that we’ve seen investors demonstrate a strong preference for exchange-traded funds and traditional index funds to some extent. They’ve been exiting actively managed mutual funds. That has resulted in active managers having to sell positions to pay off departing shareholders, and that has led to some of these outsize capital gains.
So, it’s a little funny because the activity is really being driven by some investors wanting to be tax-efficient. The remaining investors in the actively managed funds are left holding the bag. In terms of quantifying how this year’s distributions stack up relative to years past, we’re not able to keep track of that. Anecdotally, it looks in line with recent years, especially because we’ve seen really strong performance in the large-cap growth space, the U.S. large-cap growth space. That’s been where some of the selling has gone on, where investors are liquidating their positions in these active large-growth funds. And so we’ve seen some distributions come year after year from some of these funds.
What Is Considered an Outsize Distribution?
Dziubinski: Got it. What would you say is considered an outsize distribution or maybe a concerningly large distribution?
Benz: It’s more art than science, but I’ve arrived at kind of anything over 10% of net asset value I would say is a sizable distribution. We don’t see that many distributions that are over that threshold, although we certainly have seen some that are larger than 20% or even 30% in some catastrophic cases. But most of these distribution estimates when we see them are more in the neighborhood of 3%, 5%, 7%. If you see one that’s over 10%, and especially if you’ve had kind of a serial capital gains distributor, well, you’ve got a pretty tax-inefficient situation there, and you might want to look at rectifying it.
Strategies for Funds With Distributions
Dziubinski: Let’s talk about some of the strategies that investors can use if they find that a fund that they own is going to make a capital gains distribution. Now, the first strategy is, of course, just to sit tight and to reinvest that distribution. Are there types of investors that this is a better or worse decision for?
Benz: Well, I think that the investor for whom this might be a good decision would be the one who has a lot of conviction in the position itself, so still really likes the fund and also has a lot of appreciation in the holding. That over the holding period, especially if it’s been a decade or more, he or she has a big gain in the position. Well, there you need to be concerned if you were to preemptively sell that position, you could realize your own tax bill. You could unleash your own tax bill. So, that would be the case where probably sitting tight is the best course of action. And recognizing that, well, it’s not ideal you’re essentially prepaying your tax bill, but you are getting some credit for that distribution in terms of being able to increase your cost basis.
Dziubinski: How about the opposite case? You have someone who might want to sell preemptively and then avoid receiving that capital gains distribution. Who might this strategy be right for and what should they be thinking about before executing it?
Benz: Right. A good example in this situation would be A, if the position is lower conviction, it’s something you don’t love anyway. And then a really common one, Susan, is I mentioned that we’ve had these serial capital gains distributor funds where year after year they’re on our list of funds that are making big distributions. If you’ve been reinvesting those distributions and paying the tax bill on them, you’ve effectively prepaid your taxes. Compare your current cost basis in the position, which you can find on your fund company’s website, with the fund’s current NAV. You may find those things are not too far apart, and selling to get yourself into a more tax-efficient portfolio may not cost you that much in terms of capital gains taxes.
Dziubinski: And then let’s talk about that middle ground, which is simply not reinvesting the distribution. When would that make sense for someone?
Benz: Right. Just uncheck that box, right? Where you’re automatically reinvesting those distributions. This is kind of a middle ground, maybe a chicken way to address this. If you don’t love these distributions, a fund that you hold hasn’t been tax-efficient, consider just reinvesting that distribution into something else that you like more, that perhaps is more tax-efficient. That would be particularly appropriate if you’re receiving a large distribution. Well, that’s 10% of your position right there. Just steer it into that tax-efficient ETF or index fund instead.
Dziubinski: Well, Christine, thanks for your time in walking us through this today because there’s no one I’ve ever met who likes capital gains distributions.
Benz: Very true.
Dziubinski: Thank you. Thank you for the advice.
Benz: Thank you, Susan.
Dziubinski: I’m Susan Dziubinski with Morningstar. Thanks for tuning in.
Watch “Must-Knows About Required Minimum Distributions as 2023 Winds Down” for more from Christine Benz.
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.