Why You Should Pay Attention to Capital Gain Distributions



What do you think of when you hear the word "gain?" For the most part, a gain denotes something positive and is generally defined as having more of something than when you started whether that be money, or endurance.


In the world of investing, the two most common types of gains are "realized" gains, when you sell something for more than what you purchased it for, and "unrealized" gains, which represent the amount your investment has appreciated in value.


There is, however a third type of gain that starts to emerge as a trending topic in the financial community around this time of year and that is capital gain distributions. Capital gain distributions, despite what their title would suggest, represent more of a tax nuisance than an actual profit.


What Are Capital Gain Distributions?



Capital gain distributions are payments made to holders of mutual funds in the form of cash, or additional shares. Because mutual funds are classified as regulated investment companies, they're required to pay out, or distribute any and all realized gains incurred within their fund to their shareholders.


This may sound harmless but if you're not careful, you may wind up with a large, unexpected tax bill come April 15th as those distributions may be taxable.


What's the Problem with Capital Gain Distributions?



One of the big problems with capital gain distributions is that they're taxable to you if the fund(s) distributing said gains are held in a taxable account such as a brokerage account. And this is true regardless if you receive the distribution in the form of cash, or elect to reinvest the proceeds into the fund.


The extent of taxes owed on these distributions will depend on the nature of the gain. If the distributions are classified as short-term, you'll have to pay ordinary income tax on the distribution amount whereas long-term gain distributions are taxed at more favorable long-term capital gains rates.


Another issue with capital gain distributions that's both irritating and confusing to investors is that the funds may still distribute a taxable gain distribution even if your fund value declined.


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This is because mutual funds distribute gains based on what the fund managers sold for a profit during the year which may not be enough to counter other losses on investments they've yet to sell or realize.


When to Expect Your Distributions



Generally speaking, mutual fund companies distribute capital gain distributions towards the end of the year and begin releasing distribution information early to mid-4th quarter. Those interested in monitoring their funds for future gain distributions can look to the Mutual Fund Observer which is a good resource for this type of information.


If you own mutual funds in a taxable account, here are some strategies to consider that will help you limit the amount of income taxes owed when you file your return next year:


Limit income taxes owed on capital gain distributions by taking these actions now:


1. Position Mutual Funds in Tax-Advantaged Accounts



In the financial industry, advisors will refer to this as "asset location," which is just a fancy term that means placing tax-inefficient investments like mutual funds in tax-deferred accounts such as IRAs and 401ks and reserving tax-efficient investments (i.e. ETFs) for taxable accounts like a brokerage or revocable trust.


By doing so, you're limiting the potential for a surprise tax increase by taking capital gain distributions completely out of the equation since they aren't taxable if held within an IRA or 401k. Further, ETFs are structured differently than mutual funds and as such, pay limited to no capital gain distributions to shareholders.


So if you're using both active (mutual funds) and passive (ETFs) investment strategies in your retirement plan, be sure you're placing them in the right type of accounts.


2. Keep an Eye on Fund Turnover



If you must invest your taxable monies into actively managed mutual funds, please pay attention to the turnover ratio.


A fund's turnover ratio will tell you how often the fund exchanges old investments for new ones. The higher the turnover ratio (anything over 50), the more you can expect to pay in fees and taxes. A low turnover ratio (generally less than 20), however may mean the fund is being too passive and simply replicating the index it intends to beat while charging fees in excess of the equivalent index fund or ETF.


There's no secret sauce or formula here for determining the right level of fund turnover. Shopping for mutual funds is no easy task, especially if you intend to hold them in a taxable account. Be sure to pay attention to the turnover ratio as it will likely indicate how big, or small your taxable gain will be in a given year.


3. Compare Unrealized Gain to Capital Gain Distribution



A simple way to avoid paying taxes on an upcoming capital gain distribution is to sell the fund in advance. However, you may have an unrealized gain already built into your fund which would trigger a taxable event if sold.


If this is the case, you'll want to compare the upcoming capital gain distribution to your unrealized gain before doing anything. For example, let’s say you own $100,000 of XYZ mutual fund that you purchased 2 years ago for $75,000, leaving you an unrealized gain of $25,000. After checking the Mutual Fund Observer, you find that XYZ mutual fund is paying a 15% long-term capital gain distribution this year, or $15,000.


Since the capital gain distribution of $15,000 is less than the unrealized gain $25,000, it would make more sense to hold the fund and pay taxes on $15,000 as opposed to selling and owing taxes on $25,000.


It should be noted that capital gain distributions can be both short- and long-term in nature. As such, it's important to not only compare the amount of the fund's distribution to your unrealized gain, but also the type of distribution to your holding period. Had the 15% capital gain distribution in the example above been short-term, it may be more advantageous to sell, since the $25,000 gain would be taxed at long-term capital gain rates (held longer than 1-year) compared to the ordinary income taxes owed on $15,000.


4. Harvest Losses if Possible



Another way to minimize the tax impact of capital gain distributions is to harvest, or sell other positions in your portfolio with unrealized losses. This is known as tax-loss harvesting which I've detailed more here.


Harvesting losses can help offset other realized gains in your taxable account. While you're only able to deduct $3,000 in capital losses against earned income in a given year, there's no limit to the amount of realized losses you can deduct against other realized gains.


For example: You own $100,000 of XYZ fund in a taxable account that's paying out a 15% long-term capital gain distribution this year. You also own $82,000 of Facebook (or Meta) stock that you purchased for $100,000 2 years ago. If you sold your Facebook stock, you'd realized an $18,000 loss that could offset all of your $15,000 long-term capital gain distribution and leave $3,000 in excess losses to use as a deduction on your tax return.


As with most investment strategies such as loss harvesting, there are tax consequences and rules you must follow. Please remember to consult with a tax or financial professional about your situation before taking action.


Final Thoughts



Not all gains in the financial realm are created equal.


One of the drawbacks to investing in actively managed mutual funds is the potential increase in taxes resulting from capital gain distributions. But if you're careful in how, and where you put your money, you may be able to reduce or even eliminate these taxable gains altogether.


When investing in mutual funds, be cognizant of the type of account housing your funds and ensure you're maximizing tax efficiency when at all possible. It also pays to be mindful of the fund's turnover ratio and to look for creative ways to mitigate your tax liability whether that be selling your fund before the gain is distributed, or harvesting losses in your portfolio.

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