By: Joseph Goldy, CFP®
Around December of every year, investors may notice a drop in value in their mutual fund positions due to the funds paying out their annual capital gains distributions.
It is important to realize that when this payout occurs, it will cause a drop in the fund's value since the fund's share price is reduced by the capital gains distribution, making it appear that the fund lost value.
For example, if XYZ Fund is $10.00 per share and it pays out a $1.00 capital gain distribution, the price of the fund will be $9.00 per share, and the investor will receive either $1.00 per share in cash or $1.00 per share in shares via reinvestment.
It simply takes a day or so for the data providers to adjust for the distribution and properly reflect the fund's pricing in the portfolio.
Mutual funds typically pay out their capital gains once per year in December. Yearly distributions result from trading activity by the portfolio manager throughout the year, along with dividends and interest from the stocks or bonds within the fund.
Tax Repercussions of Mutual Fund Capital Gains Distributions
While the annual capital gains distributions do not affect the fund's total return, they are a taxable event if they are held in a taxable account, regardless of whether the gains are reinvested in the fund.
No matter how long an investor has held shares of the fund, the capital gains distribution could be classified as short or long-term.
Strategies to Help Minimize the Tax Liability of Mutual Fund Capital Gains Distributions.
1. Mutual Fund Turnover
Mutual fund turnover refers to how much the portfolio is traded or "turned over" each year. Turnover is expressed as a percentage, and funds with higher turnover generally have higher capital gains distributions. The average mutual fund turnover is a little over 63%, meaning 63% of the fund's portfolio is being replaced in a year.
At Highland, the weighted average of our actively managed funds is around 35%. Turnover ratio is just one metric that should be looked at when researching a fund but an important one, as it may indicate a fund manager who is excessively trading the fund's portfolio.
2. Asset Location
Asset location refers to the deliberate placement of investments in specific accounts based on their tax characteristics to achieve overall tax efficiency. For example, taxable investment accounts, Traditional IRAs, and Roth IRAs have different taxation properties. Thus, putting growth mutual funds with higher turnover in an IRA negates any tax liability from the capital gains distributions. Asset location is an essential aspect of proper portfolio management.
ETFs vs. Mutual Funds
By design, when you place a buy or sell order for a mutual fund, your order is handled directly by the fund company. Sell orders coming in throughout the year coupled with regular trading activity by the portfolio manager causes capital gains to build, which are ultimately distributed.
In contrast, ETFs trade in the secondary market like a stock, so when the ETF is bought or sold, it does not cause any forced selling within the actual portfolio of the fund. ETFs use a unique mechanism of redeeming and creating shares through third parties called authorized participants, making them more tax-efficient for investors.
If you are performing any year-end tax planning with your accountant and would like assistance or information regarding your capital gains, interest, and dividends this year, please reach out to your Advisor.
Joseph Goldy, CFP®, is a wealth advisor and CERTIFIED FINANCIAL PLANNER™ at Highland Financial Advisors, LLC, a fee-only fiduciary wealth advisory firm based in Wayne, New Jersey.
Joe specializes in working with newly independent women because of divorce or losing a spouse. He understands firsthand the value of having a clear financial picture pre- and post-divorce and a plan to restate goals as a single person. When he is not helping clients, Joe enjoys spending time with his two sons outdoors and volunteering to help raise money for Type 1 diabetes organizations.