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Portfolio > Mutual Funds

How Fund Capital Gains Could Hurt Investors — Even With Market Losses

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What You Need to Know

  • Mutual fund companies have started posting estimates for the 2022 capital gains distributions they plan to make before year-end.
  • This year’s selloff triggered fund outflows, so some fund managers have had to realize capital gains to meet redemptions, says Morningstar's Stephen Welch.
  • Capital gains distributions are often reinvested back into funds, but each investor must decide whether or not to do so.

Clients who’ve sustained big portfolio losses in this year’s tumultuous financial market do not want to take a tax hit, too. But as mutual funds prepare to make capital gains distributions, advisors should consider alerting clients to this issue and discussing potential moves to mitigate their tax bills.

Mutual fund companies have started posting estimates for the 2022 capital gains distributions they plan to make before year-end, according to a column posted last week by Stephen Welch, manager/research analyst of equity strategies for Morningstar Research Services. Plus, several funds that sustained big losses have already indicated they’ll make significant distributions, he points out.

Morningstar listed 24 major fund families that estimate they’ll make moderate to large capital gains distributions between late November and Dec. 31. 

Source of Gains

While 2022 certainly has been rocky for investors, Welch wrote, “many funds entered this year holding appreciated assets from a strong 2021 and the long bull market before 2020.”

This year’s selloff triggered fund outflows, and many investors replaced actively managed stock funds with passive exchange-traded funds. As a result, some fund managers have had to realize capital gains to meet redemptions, he explained.

“A lot of these funds have seen redemptions as the stock market has decreased in value … meaning that they have to sell off assets to meet cash demand,” he told ThinkAdvisor in an interview Monday. Strong market growth over the past decade, excluding 2022, has translated into capital gains distributions, he adds.

Meanwhile, the Morningstar U.S. Market Index logged a nearly 19% decline this year through Oct. 31. 

“Investors with taxable accounts owe taxes on distributed gains even if they reinvested them, unless they’ve sold losing positions to offset the gains,” Welch explained in his article.  These concerns pertain primarily to funds held in taxable accounts.

Funds & Tax Deferrals

Mutual funds held in 401(k) or other tax-deferred accounts receive the capital gains distributions, but investors aren’t liable for the tax implications until they start taking withdrawals from these accounts, he told ThinkAdvisor. These capital gains distributions are often reinvested back into the fund, but each investor must decide whether or not to do so with his or her holdings.

Actively managed mutual funds tend to have more capital gains distributions, according to Welch. In contrast, most passive mutual funds, which typically track market indexes, don’t sell assets throughout the year or make big moves with individual holdings, unless something is rotated out of the index.

And ETFs, which are structured differently from their mutual fund counterparts, generally don’t pass along capital gains distributions to investors, who realize capital gains only when they sell appreciated shares, Welch said. 

Mitigating Tax Consequences

Harvesting some capital losses to offset taxes on capital gains distributions from mutual funds held in taxable accounts is likely the easiest course of action, Welch said in the interview.

Investors also could sell the mutual fund before the capital gains record date — which fund companies publish online — and buy another vehicle. However, they might be hit with front-end fees that would offset the savings, he said. Clients also might incur capital gains taxes on the sale.

Advisors and clients would need to be aware of these potential costs and decide on a case-by- case basis, Welch added.

ETFs generally have very low fees, so shifting a mutual fund investment into an ETF could be a reasonable strategy to explore, he said.

Time to Abandon Traditional Funds?

Rick Ferri, financial advisor, ETF fan and “Bogleheads on Investing” podcast host,  sees mutual fund capital gains distribution as a reason for investors to make a change.

“Unwanted capital gain distributions are another reason 2022 is an ideal year to sell remaining active equity mutual funds in a taxable account and switch to broad market equity ETFs,” he said last week on Twitter, which cited Welch’s Morningstar article. (One tweeter responded that he’d been selling his taxable active mutual funds for that reason, and noted tax-loss-harvesting opportunities have helped.)

Reinvested capital gains distributions help increase clients’ cost basis, which could reduce their eventual capital gains taxes when they sell the fund, Morningstar’s Welch noted in his article.

“So, if you hold a serial capital-gains-distributing fund, selling it in the future may cost less than you anticipated, owing to all the cost-basis step-ups that the regular distributions triggered,” Ferri said.

“Taxable investors considering buying a fund that has predicted it will make a distribution also may consider delaying the purchase until after the payout to avoid getting distributions without the benefit of any gains,” he added.

(Image: Adobe Stock)


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