Every year around this time, fund companies start publishing estimates of the capital gains distributions they expect to pay in November and December. For investors holding mutual funds in taxable accounts, those estimates are worth more attention than they usually get. A large distribution can mean a tax bill on gains you never personally realized, from a fund you may not have sold a single share of.
This year has the ingredients for some sizable payouts. Stocks have had another strong run, with the S&P 500 up roughly 16% over the past year and the Nasdaq back at record highs this week. And the shift of money out of mutual funds and into ETFs has kept accelerating, with U.S. ETFs taking in more than $1 trillion in new money over the past year. That combination tends to be tough on the investors who stay in actively managed mutual funds.
Here’s why. A mutual fund has to distribute its net realized capital gains to shareholders each year. When a fund sells holdings at a profit, whether because the manager is repositioning or because it needs cash to meet redemptions, those gains pile up inside the fund and eventually get paid out. When a lot of shareholders are leaving, the fund may have to sell appreciated stocks to raise the cash, and the gains from those sales get distributed to whoever is still holding shares at the record date. The investors who left escape. The ones who stay pick up the tax bill.
ETFs largely avoid this through the in-kind creation and redemption process, which lets them hand off low-cost-basis shares to market makers rather than selling them. That’s the main reason most broad equity ETFs rarely distribute capital gains at all, and why a long stretch of redemptions from active mutual funds can produce distributions of 5%, 10%, or occasionally more of a fund’s NAV.
The first practical step is simply checking the estimates. Most large fund families post preliminary figures between mid-October and mid-November, often with a record date and an ex-date. If you hold active equity funds in a taxable account, look up each one. Pay particular attention to funds that have had strong performance, high turnover, or heavy outflows over the past year or two. Those are the ones most likely to surprise you.
The second step is avoiding what’s often called buying the distribution. If you invest in a fund shortly before its record date, you’ll receive the distribution and owe tax on it, even though the fund’s share price drops by roughly the amount paid out. You haven’t lost any value, but you’ve converted part of your investment into a taxable event for no benefit. In a taxable account, if you’re planning to add money to a fund in November or December, it often makes sense to wait until after the ex-date. This doesn’t matter in an IRA or 401(k), where distributions aren’t taxed when paid.
The third step is deciding what to do about funds with large expected distributions. There’s no single right answer. If a fund is expected to pay out a large gain and you’ve been meaning to move on from it anyway, selling before the record date means you realize your own gain or loss rather than receiving the fund’s. If your cost basis is lower than the current price, that may still be a taxable sale, so run the numbers. If you have losses elsewhere in your portfolio, harvesting them before year-end can help offset what the distribution will cost you. Either way, it’s a decision best made in October or early November, while there’s time to act.
For investors in some fund families, there’s a newer option worth checking. Since the SEC began granting relief last year, a growing number of managers have added ETF share classes to existing mutual funds. Some of those funds allow shareholders to exchange mutual fund shares for ETF shares of the same fund, and exchanges between share classes of the same fund generally aren’t treated as taxable sales. That can be a way to move into a more tax-efficient wrapper without triggering gains, but the details vary by fund and custodian, so confirm the specifics before assuming it applies to you.
The bigger lesson here is about asset location, meaning which types of funds you hold in which types of accounts. If you have both taxable and tax-advantaged accounts, it usually makes sense to hold the least tax-efficient investments inside IRAs and 401(k)s. That includes actively managed stock funds with high turnover, taxable bond funds, REIT funds, and most income-oriented strategies that produce ordinary income. The more tax-efficient holdings, such as broad index ETFs, municipal bond funds, and individual stocks you plan to hold for a long time, generally belong in taxable accounts.
Getting asset location right doesn’t require selling everything and starting over. You can move toward it gradually by directing new contributions to the right place, rebalancing inside tax-advantaged accounts where trades don’t create tax consequences, and choosing more tax-efficient vehicles when you add money to taxable accounts.
Capital gains distributions aren’t a sign that a fund is doing something wrong. A fund that performs well and gets hit with redemptions is going to distribute gains. The cost to you depends mostly on where you hold it and whether you see the distribution coming. A few minutes with the estimates this fall can be the difference between a planned tax event and an unwelcome surprise next April.