Ah, December. Time to put up those festive decorations, bake (or buy) some tasty treats—and brace for mutual fund capital gain distributions. Distributions are an annual, taxable event, yet still a mystery to many investors.

What Are Capital Gain Distributions?

You’re probably already aware: If you sell a holding from your taxable account for more than you paid for it, you must report the capital gains on your tax return. In similar fashion, mutual funds must distribute to shareholders any net profits from their recent underlying trading activities.

In a year when stocks have enjoyed significant and relatively steady positive returns, many mutual funds have incurred net positive gains. Most of those underlying gains will be distributed to shareholders right around now, in mid-December.

What does this mean to you? Whether or not you incurred taxable gains to report from your own 2021 trading activities, expect some from your funds’ capital gain distributions.

After all, if a fund never sold any of its underlying holdings at a profit, it would be unlikely to generate any positive returns.

How Do Distributions Work?

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

For example, say you are invested in a fund trading at $20 per share, and it distributes a 5% long-term capital gain of $1. After the distribution, your shares would be worth $19 per share, and you’d receive $1 per share in cash (or in new fund shares if you’ve elected to have dividends reinvested).

The combined value of the $19 share + $1 cash equals the pre-distribution amount invested. However, if you own the fund outside of a retirement account (or similarly tax-sheltered account), you must report the $1 per share as a taxable distribution. Again, this is true even if you personally made no trades in that fund during the year.

Also, keep in mind, since the cash distribution is not always received into your account until the following day, it can temporarily appear as if the entire account has lost value. Not to worry; it will show up again shortly.

What Can We Do About Distributions?

Taxable year-end capital gain distributions aren’t the kind of holiday surprise anyone would prefer to receive. That’s why we take year-round steps to minimize them. Following are some of the ongoing efforts we take:

Avoiding Actively Managed Funds

First, we favor tax-friendly index- and exchange-traded funds from managers such as Vanguard, and broad-based asset-class funds from managers such as Dimensional Fund Advisors. These funds tend to trade their holdings much less frequently and more patiently compared to traditional actively managed funds. Infrequent trading helps keep a lid on taxes, ensuring more returns end up in your pocket, rather than in the hands of the IRS.

In contrast, active managers’ frenetic efforts to “beat the market” leaves them more frequently darting in and out of underlying holdings. This often generates extra capital gains in general, as well as more short- vs. long-term gains, which are taxed at higher rates. Big picture, this sort of hyperactive trading is not expected to generate extra expected returns for you, the shareholder, and can add unnecessary tax costs along the way as well.

Asset Location

We also routinely consider asset location, or selecting the best type of account for each kind of investment. We prefer to hold funds that are less likely to generate distributions in clients’ taxable accounts. We then try to reserve tax-sheltered account space for funds that are not quite as tax-friendly.

Tax-Loss Harvesting

We also strategically use tax-loss harvesting—trimming positions trading at a loss and immediately replacing them with a similar investment—to offset gains realized elsewhere.

Managing Trades Around Capital Gain Distribution Dates

Fund managers do announce the timing and rates of their expected capital gain distributions at least a month or two in advance. So informed, we may hold off on investing new cash in your taxable accounts if a fund is about to make a large distribution. By investing according to plan, but after distributions are paid, we can sometimes avoid the additional tax liability.

To Summarize

While, in general, we don’t like large capital gain distributions, it’s not the absolute level of distributions that’s of most importance. It is the strategy’s net return, after any taxes paid on those distributions, that matters most. And, in that sense, it’s shaping up to be a very good year.