Managing Mutual Fund Taxes

Next month, mutual funds are required to distribute to shareholders any profits realized from trading, net of any losses. In turn, shareholders are obligated to pay taxes on this income.

These capital gain distributions can be an unwelcome surprise for investors with taxable accounts.

How Distributions Work

When a distribution is paid, a fund’s share price declines by the amount of the distribution.

Should a fund trading at $20 per share, for example, make a 5% long-term capital gain distribution of $1, a fund investor would subsequently have one share worth $19 and $1 in cash.

The combined value of the $19 share and $1 cash equals the pre-distribution amount invested; however, shareholders owning the fund outside of a retirement account will owe tax on the $1 distribution. This is true even if the shareholder made no fund sales during the year.

Keep in mind that since the cash distribution is not always received into an investor’s account until the following day, it can temporarily appear as if the entire account has lost value.

Maximizing Returns

While taxes on end-of-year mutual fund capital gains can be unpleasant, we take steps year-round to minimize impacts.

We favor tax-friendly index- and exchange-traded funds from Vanguard and broad-based asset class funds from Dimensional Fund Advisors (DFA). These funds tend to trade their holdings much less frequently compared to traditional actively managed funds, whose managers frenetically dart in and out of stocks.

Less frequent trading helps keep a lid on taxes, ensuring the lion’s share of a fund’s return ends up in the investor’s pocket.

Special Cases

Not all of our funds are immune to sizeable distributions, however. Funds with a smaller eligible universe of holdings—small cap value or micro-cap stocks, for example—generally produce larger distributions (5% to 7% this year) because of their more targeted holdings.

When stock markets are volatile, as they’ve been this year, some funds are forced to trade more frequently to maintain style purity. Consistent exposure is a good thing, and one of the reasons we seek to hold these funds in clients’ retirement accounts (to minimize tax impacts) whenever possible.

Taxes Trimmed

In a year when a globally diversified portfolio is down, it may feel like salt in the wound to get a tax bill on top of that.

To minimize the pain, we proactively tax loss harvest—that is, trim positions trading at a loss and immediately replace them with a similar investment—to offset gains realized elsewhere.

We’ve Got Your Back

Regardless of their size, December capital gain distributions can catch investors by surprise.

Rest assured, we’re always working to limit the bite taxes take out of your portfolio.

 

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