It’s the time of the year when investors who hold mutual funds in taxable accounts begin to brace for a potential nasty surprise.
Each year mutual funds must pay out to shareholders nearly all their income, including interest, dividends and net realized capital gains. If you hold mutual funds in tax-advantaged retirement accounts, those shared profits don’t trigger a tax bill. Unfortunately, the same is not true of taxable accounts. In fact, a fund can even post a negative return for the year and still distribute gains that shareholders will owe taxes on. This scenario poses a real risk in the current volatile market where fund managers may have had to sell stocks in order to handle a lot of redemptions.
Active managed mutual funds with high turnover are typical offenders when it comes to capital gains distributions. How large can these gains be? A recent Wall Street Journal article Beware of Tax Surprises Lurking in Mutual Funds reported recently on the largest capital-gains payout experts can remember. According to the Journal, “First Pacific Advisors said that as a result of a strategic shift, its FPA U.S. Value Fund, formerly the FPA Perennial Fund, paid out capital gains of $39.67 per share this year, which equaled about 82% of the fund’s net asset value at the time of the announcement. According to Morningstar, the fund was down 4.61% this year through November 12.”
Many of the investment firms that haven’t already estimated capital-gains payouts for 2015 will probably do so in the next few weeks. Distributions are listed on fund firms’ websites, but they can take some hunting to find. If you’d rather not play detective, try consulting the free site, CapGainsValet.com.
I looked at 15 of the largest actively managed mutual funds and noticed that some did not have the data available yet. And some were estimating no capital gains distributions while others were estimating capital gains distributions as high as 9%. If you expect a high capital gains distribution from one or more of your mutual funds, you may want to seriously consider selling the fund before the ex-dividend date.
I’ll end by noting that these capital gains distributions often make buying into a fund at this time of year something to carefully consider. If you buy in November and gains are distributed in December, you will end up being taxed on gains you did not participate in for the full year.