Even if you don’t sell any mutual fund shares in 2015, you still might be subject to a hefty tax bill if you are a mutual fund owner. Here’s why – and how you might avoid the potential tax consequences during mutual fund capital gains season.
When you purchase a mutual fund, you own shares of a trust which then purchases different types of assets. Those assets are likely to be individual stocks and bonds, but can also include futures contracts, options, precious metals, among other things. When that mutual fund sells an asset for a profit, it must pass those gains onto you, the shareholder, every calendar year. They do this in the form of short and long term capital gain distributions, and generally make them in the month of December.
The capital gain distribution affects each individual investor differently, depending on their individual tax situation. Short term capital gains are taxed at ordinary income rates. Long term capital gains rates, on the other hand, generally receive a somewhat preferential tax treatment. Depending on your tax bracket, your long term gains rates may be are taxed at 0%, 15%, or 20% (and sometimes higher depending on the type of investment and if you qualify for the Medicare surtax). This article discusses long term capital gains rates in more detail.
Here’s what to do to help alleviate unnecessary taxes:
1. Visit your mutual fund’s website to determine if they will be making a distribution
Almost every mutual fund family has posted their capital gains distribution estimates as of the drafting of this article. The easiest way to find this information is to find your mutual fund website, and type in ‘tax’ into the search bar on their homepage. If you find their website less than helpful, find their contact information and phone their service desk. The estimates you receive from the mutual fund company are usually expressed in dollars and cents terms. Divide the estimated distribution by the fund net asset value (NAV) and you will understand how big the distribution will be as a percentage of assets. In my opinion, anything greater than an 10% distribution is reason for concern.
2. Review your current mutual fund holdings before December
A proper review of your current holdings, using the same metrics and fundamentals you’ve used to choose them in the first place, will help you identify if any of your funds should be sold. You might want to sell them before they make a capital gains distribution. Another reason you might want to sell a fund before it makes a distribution could be that you plan on rebalancing your holdings. You will owe taxes if the cost basis (the price you paid for shares of the fund) is higher than your sale price, but if you do this before the record date for the fund, you’ll at least avoid taxes due on the capital gains distribution. If performing a rebalance, you may be able to limit your tax hit on sales if you’re using the specific share identification method for cost basis to unload the highest cost shares.
3. Buyer beware
Investors who could get hit hardest from the end of year tax distributions are those who have recently purchased or plan to purchase funds which plan to make a large capital gain distribution. These are people who purchase the fund before the distribution, miss out on the gains from the previous few years, and get hit with the taxable distribution anyway. Don’t purchase any fund until you’ve checked to see if it is making a 2015 distribution.
4. Consider offsetting the gain
If you are facing large capital gains distributions sift around your portfolio for losses that could offset those gains. Commodities, energy stocks, and emerging markets stocks have all taken a beating this year and could be ripe for the picking. Also, don’t forget to look at last year’s tax return and check if you’re carrying forward any losses that may offset your potential gains.
Note that none of this affects investors who hold mutual funds through tax-favored retirement accounts such as 401(k), IRA, 403(b), 457, etc. They do not have to pay annual taxes on fund earnings.