Year-end is a natural time for investors to review their portfolio’s performance and while it’s a good idea to check in on your portfolio, mutual fund shareholders who are not monitoring for the potential tax impact of year-end mutual fund capital gains distributions may be caught off guard.
A mutual fund is an investment vehicle that pools together monies from multiple shareholders to purchase securities, typically stocks or bonds. Shareholders receive benefits such as diversification, as the fund will hold many securities for which it can be unrealistic for an individual to conduct due diligence on, professional expertise provided by the fund’s managers and technological resources leveraged by the fund’s technicians. Throughout the year, mutual funds will make buys and sells to ensure that their strategy remains in line with their stated objectives and to take advantage of any market dislocations.
Depending on how long these assets were held by the mutual fund, profitable trades may fall into one of two taxable categories, short-term and long-term capital gains. Short-term is applicable for investments held for less than one year and is generally taxed as ordinary income, while long-term applies to positions held for longer than one year and is taxed at the long-term capital gains rate (the distributions are taxed only within taxable accounts such as a trust, joint or individually held investment account). Mutual funds are mandated by law to distribute at least 98% of their net capital gains (after “netting” out trades with losses and gains) to shareholders once per year. Typically, mutual fund distributions are paid out in November or December and can consist of both short-term and long-term capital gains.
Given mutual funds may execute hundreds or thousands of trades each year, estimating your resulting tax liability can be quite challenging, but failure to do so can leave you susceptible to significantly underestimating what you owe in April, and can even result in moving you into another tax bracket. It is also important to weigh the difference in taxes between selling the fund prior to the distribution date or holding onto the fund and taking the distribution. Without properly estimating the tax implications, mutual fund distributions can represent lost opportunities to offset losses or execute carryforwards, and in some circumstances, can leave an investor wide open for headaches come April.
Mutual funds can be a practical part of one’s investment allocation and our Investment Management process includes evaluating all mutual fund distributions, no matter the size. And for each client we serve, we monitor and estimate the tax implications from all such distributions. This allows us to make investment trades throughout the year to minimize the tax bill, and to more efficiently rebalance and align each client’s portfolio to support their unique goals.
