How to Manage Capital Gains Distributions in 2024

Key Takeaways

• If a fund has a gain in a security and then sells that security, it must distribute those capital gains to shareholders on record within its fiscal year. Even if you reinvest that distribution back into the fund to buy more shares, you still will pay taxes on that distributed amount. The other set of taxes would apply if you have a gain in a fund and you sell, you will also owe taxes on that gain.
• We’ve had several straight years where funds have been making somewhat sizable distributions. Even funds that don’t have particularly good results still have substantial gains on their books, and we expect that trend to potentially continue in 2024.
• A concerningly large distribution for a fund from a percentage standpoint could be around 10% of net asset value. But if you have a substantial holding in a fund, even a 5% distribution can be meaningful in terms of your tax bill.
• One strategy that investors can use is to sit tight and reinvest that distribution. Another strategy would be selling preemptively before that distribution is made. Lastly, investors could keep the fund, take the distribution, and not reinvest it.

Susan Dziubinski: Hi, I’m Susan Dziubinski with Morningstar. We’re deep into the fourth quarter, and that means some funds will be making capital gains distributions to shareholders. Joining me to discuss how to deal with these distributions is Christine Benz. Christine is Morningstar’s director of personal finance and retirement planning, host of The Long View podcast, and author of the bestselling book, How to Retire: 20 Lessons for a Happy, Successful, and Wealthy Retirement. The book is getting rave reviews on Amazon, so be sure to pick up a copy.

Congratulations on the book, Christine. Nice to see you.

Christine Benz: Thanks so much, Susan.

Why Do Funds Make Capital Gains Distributions?

Dziubinski: All right. Before we dive into some specific strategies that investors might use to help mitigate the tax issues around capital gains distributions, let’s discuss why funds make these distributions in the first place.

Benz: The starting point is if a fund has a gain in a security and then it sells that security, it must distribute those capital gains to shareholders on record within its fiscal year. That’s why we see this avalanche of distributions typically in the November-December period. We’ve been through a good decade of sizable capital gains distributions from a lot of mutual funds.

How Do Taxes on Capital Gains Distributions Work?

Dziubinski: Christine, how do taxes work on these capital gains distributions that funds may make?

Benz: If you’re a shareholder of record at the time a fund makes a distribution, even if you reinvest that distribution back into the fund to buy more shares, you still will pay taxes on that distributed amount. So, it’s important to remember that that’s kind of one set of taxes that you might pay as a fund shareholder. The other set of taxes would apply if during your holding period of a fund, you have a gain in it and you sell, you will also owe taxes on that gain. It’s kind of the first set of taxes, these capital gains distributions are something that we as fund shareholders don’t have a lot of control over. That’s one reason why they tend to frustrate investors.

Dziubinski: So irritating.

Capital Gains Tax 2024

Dziubinski: So now you mentioned earlier that we’ve had several straight years now where funds have been making somewhat sizable distributions. Why is this happening and what do estimated distributions look like in 2024 compared to prior years?

Benz: The macro story is that we have had this long-running trend of investors swapping out of actively managed funds into mainly exchange-traded funds or index trackers at large. And so that has caused these active funds to have to sell securities. And of course, the overhang is that we’ve had a really great stock market. So, even funds that don’t have particularly good results still have substantial gains on their books. That has triggered a lot of selling and it has been a negative for fund shareholders. When we drill down and look at some of the biggest capital gains distributions that we’re expecting for 2024, a lot of them are situation-specific stories, oftentimes maybe a manager change or some really large exodus of shareholders that has triggered some selling. When we compare capital gains distributions this year relative to past years, I don’t know that we have summed up the amount of distributions that we expect to see coming, but it’s been part of a broader trend where this has not been a great situation for shareholders in active funds.

What Size Distribution Should You Be Concerned About When Tax Planning?

Dziubinski: What would you think is a concerningly large distribution for a fund from a percentage standpoint?

Benz: Sort of arbitrarily, I’ve kind of thought about 10% of net asset value as being a pretty large distribution. But if you have a substantial holding in a fund, even a 5% distribution can be meaningful in terms of your tax bill. So, it’s hard to say you shouldn’t be concerned about anything under 10% because if it is a big position for you in the fund, it can add up and start to have knock-on effects throughout your tax return for the 2024 tax year.

How Do You Avoid Capital Gains Distributions Through Selling?

Dziubinski: Let’s talk a little bit about some of the strategies that investors can use if a fund or funds that they own are about to make maybe a big distribution. The first strategy is of course just sort of sit tight and reinvest that distribution. Who do you think should consider that strategy? And if that is you and you decide to do that, is there any way to sort of mitigate that tax bill or do you just have to take it?

Benz: Good question, Susan. And I would say this would tend to be most appropriate for the person who still has a lot of enthusiasm for the investment. And maybe the best example would be if you think it’s a really undervalued holding for whatever reason, and you still like the fund itself, then you might want to just reinvest back into the fund. In terms of mitigating the tax effects, you could look around for tax losses in your portfolio to help offset that gain. But we’re several years into a really great bull market. I’m not sure how many investors have big losses in their portfolios today.

Selling a Fund Before a Distribution Is Made to Avoid Capital Gains Tax

Dziubinski: The opposite case would be selling preemptively and before that distribution is made. Who is that strategy right for? And what should investors consider before they take that route?

Benz: This would be a great scenario for someone who has, is not a fan of the fund that is about to make a distribution. It’s something that you wanted to sell anyway, probably for fundamental considerations. And so selling preemptively would help you dodge that forthcoming tax distribution. But you still would owe potentially some sort of capital gains on the spread between your cost basis and what you sell it at. You want to keep that in mind before preemptively selling. If it has been what I call kind of a serial capital gains distributor, and we do tend to see some patterns here where funds just keep doing this and they keep having the asset outflows. If the fund has followed that pattern, you have been able to increase your cost basis in line with these distributions. And so that will mean that when you come around to sell the fund, you may actually owe less than you think you will. So, do the math, and check your cost basis, but that can be the right strategy if you don’t have a lot of conviction in the investment.

When Investors Shouldn’t Reinvest Capital Gains

Dziubinski: There’s sort of this middle-ground strategy, which is you just don’t reinvest the distribution. You keep the fund, you take the distribution, you don’t reinvest it. Who does this make sense for?

Benz: This would be if you still have conviction in the underlying holding, but do not want to put more toward that fund that’s making big capital gains distributions. The idea of reinvesting that distribution in something else makes a lot of sense. A great example here would be you’ve got this large-growth fund, for example, that has been making distributions. You like the fund itself, but you don’t necessarily want to put more money into large growth. The tax effects are the same. If you have that distribution sent to your cash account or have it sent to your small value or international fund or whatever the case might be. That is a way to not put additional funds behind the fund that has been kind of tax-unfriendly to you.

Dziubinski: And then just one quick wrap-up: This only applies to people who own funds in their taxable account. If you have this in a tax-deferred account, you don’t have to worry about it right now.

Benz: Wonderful point. Exactly, Susan. So you can tune this whole thing out. If all of your holdings are in tax-sheltered accounts, you don’t have to worry about this. This only applies to taxable holdings.

Dziubinski: Well, great. Thank you for your time, Christine today, and for these strategies. We appreciate it.

Benz: Thank you so much, Susan.

Dziubinski: I’m Susan Dziubinski with Morningstar. Thanks for tuning in.

Watch 5 Must-Knows About RMDs as 2024 Winds Down for more from Christine Benz.