Brace yourself for a large tax hit from mutual-fund payouts
Amid the holiday cards coming in the mail and inboxes this season is a potentially not-so-nice greeting for some mutual-fund investors: capital-gains distributions.
It’s not all bad news. A number of funds are paying out gains because stocks gained this year, with the S&P 500 index
up 22% through November (and has continued rising in December). International markets also performed well, with the MSCI ACWI index
up 16.8% in the same 11 months.
But the lump-of-coal part is a possible tax bill.
Mutual-fund investors with holdings in taxable accounts need to prepare for a tax hit on distributed gains — even if they reinvest the distributions. They can offset some or all of the gains (and taxes) if they’ve sold positions at a loss.
People who own mutual funds in tax-sheltered accounts such as 401(k)s or individual retirement accounts and are reinvesting the distributions, on the other hand, don’t have to worry. In those accounts, taxes only count when investors sell holdings in retirement, and those who have funds in qualified Roth IRAs won’t have to pay even then.
Fund companies generally estimate their distributions based on share prices between the end of September or October. This information is found on the fund company’s website, usually under information about taxes. Payouts are described in percentages of assets, based on share prices at the time of the estimate.
Mutual funds vs. ETFs
There’s a second big reason beyond a great year for stocks that explains why fund companies overall are paying out capital gains: the trend of investors moving assets out of mutual funds and into exchange-traded funds, said Christopher Franz, associate director of equity strategies, at Morningstar.
For the past several years, mutual-fund companies have seen their assets flow out on speed skates and into exchange-traded funds, in large part because of lower fees and tax efficiency. In many cases, actively managed funds are losing money to mostly passively managed ETFs.
Because of how mutual funds are structured, when investors sell their mutual-fund holdings, the portfolio managers need to sell assets to pay those redemptions. Unless they can offset those gains with losses, the managers book those gains and pass them on to shareholders.
ETFs are tax-efficient because the creation/redemption process mitigates some of these capital-gains distributions. There are rare times when ETFs pass on capital gains.
This mutual fund structure explains why investors who own mutual funds in taxable accounts get hit with capital-gains distributions even if they didn’t sell a single share, a very Grinch-like outcome.
“It’s just a brutal reminder that within the mutual fund structure … it essentially socializes the cost of doing business,” Franz said.
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Distributions are larger than in the past
Morningstar annually spot checks capital-gains distribution rates for about two dozen of the major fund families, and Franz said this year’s trend is pretty typical to last year. The firm doesn’t have any broad average numbers on the average payout or percentage size of distribution because the data set is too wide, but anecdotally the firm notes distributions are bigger now than what they were historically. The combination of redemptions and strong stock market gains are increasing payout sizes, he said.
There can be specific reasons for why a fund has a high payout, such as changes in managers, strategies or indexes.
For the past few years, growth funds investors have contended with sizable distributions because of market gains, but this year distributions are spread more widely, Franz said, including in some value-oriented strategies. Value strategies have typically lagged the broader market recently, but this year value saw a rebound.
Glen Casey, global head of products at American Century, said there’s no primary reason behind the distributions on the two funds, adding that creating capital gains is a normal outcome of changes in the portfolios. The firm may consider tax consequences when it sells a holding but it’s rarely a primary factor.
“For both Disciplined Core Value Fund and Equity Growth Fund we employ a structured, disciplined approach for both stock selection and portfolio construction, and stocks are purchased or sold based on fundamentals. In addition, as the macro-economic environment changes and new risks emerge, the funds are actively managed to balance expected returns and risks for the long term. This process will result in turnover that may lead to capital gains as we position the portfolio to what we believe are the best opportunities for appreciation,” he said.
Columbia Threadneedle’s payouts are examples of the success of growth funds, but also highlight how passive index funds can sometimes cough up distributions. The firm estimated its Columbia Large Cap Growth Opportunity
would distribute between 21% to 25% of its fund in capital gains and its Columbia Large Cap Index
between 11% to 12% of assets.
Lisa Feuerbach, a spokesperson for Columbia Threadneedle, said the capital gains in Large Cap Growth Opportunity are in part due to selling stocks that were bought during the COVID-induced market plunge in March and April of 2020.
“The higher cap gains for this year are a function of the team remaining disciplined on valuation as many securities have achieved price objectives sooner than was anticipated at initiation. While we have had changes to the portfolio management team, the philosophy and process has remained consistent,” Feuerbach said.
She also explained that the index fund will have capital gains because index funds because portfolio managers aren’t able to pick out tax-loss harvesting opportunities in to minimize distribution, being passively managed.
To minimize tracking errors and satisfy redemptions, index fund managers sell a pro-rata proportion of each stock, regardless of whether if the sale is a gain or loss. “The highest cost basis shares are sold first in an attempt to minimize the distribution, but after years of doing this, you tend to be left with a majority of low-cost basis lots,” she said. The fund is primarily used in tax-qualified accounts, so most shareholders won’t be affected by distributions, she added.
Among other well-known firms, several Vanguard actively managed funds will make notable payouts this year. Vanguard Mid-Cap Growth
VMGRX will see a 25% distribution because the fund modified its subadvisor allocation in mid-October, Franz said.
There’s also an example of a rare distribution by an ETF; the Vanguard International Dividend Appreciation ETF
changed its target benchmark earlier this year, he added.
By contrast, payouts by American Funds look relatively mild versus their peers, with many in the 5% to 8% range. Their flagship Growth Fund of America
has an estimated 6% to 8% distribution.
Vanguard, T. Rowe and American Funds did not return requests for comment.
What to do for next year
Investors who don’t want to repeat the tax pain need to think about what they want to do with their active mutual fund holdings in taxable accounts, Franz said.
The simple answer may be to sell, but that can incur gains as well. There may be strategic reasons to keep a fund in a taxable account, so that’s a discussion best had with a financial advisor.
One option open to investors is to reinvest dividends and capital gains into an ETF to reduce the problem in future. Many fund families are starting to make ETF versions of their popular mutual funds, such as T. Rowe Price Blue Chip Growth ETF
an ETF version of the popular mutual fund.
Debbie Carlson is a MarketWatch columnist. Follow her on Twitter @DebbieCarlson1.