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Unpleasant Surprise: Mutual Fund Capital Gain Distributions

Nathan Geraci is President of The ETF Store, Inc. and host of the weekly radio show "The ETF Store Show".

As the end of the year quickly approaches, it's time to start thinking about the tax consequences of investments you hold in taxable accounts. Taxes sometimes get lost in the shuffle when evaluating investments, but they can take a big bite out of returns. For investors holding mutual funds, particularly actively managed funds, you may soon receive an unpleasant surprise in the mail - notification of capital gain distributions. If you're not familiar with capital gain distributions, quite simply, they are the payment (to you) of any net gains made from positions (stocks, for example) a mutual fund manager has sold during the course of the year. The fiscal year for most mutual funds ends on October 31st, so funds will begin announcing capital gain distributions soon and investors typically receive them in December. So why would payments made to you be unpleasant? You owe taxes on these payments if the mutual funds are held in a taxable account (in 2013, the top capital gains tax rate increased to 20%, with high income earners paying an additional 3.8%).

Consider the following basic example: Let's say you own shares of a mutual fund and there is another shareholder in the same fund that wishes to sell their shares because they need cash to buy a house. In order to meet this redemption request, the manager of the mutual fund may need to sell shares of stocks held by the fund to raise cash necessary to pay this shareholder. When the mutual fund manager sells shares of stocks owned by the fund for a gain, the mutual fund is required by law to distribute those gains to all mutual fund shareholders - including you! And remember, those gains are taxable if you hold the mutual fund shares in a taxable account.

So to recap, if you're a shareholder of a mutual fund and another shareholder redeems their mutual fund shares to buy a house, you may be penalized with a taxable capital gain distribution even though you didn't do anything. That hardly seems fair. And what's worse, these capital gain distributions are "phantom gains" in that the share price of a mutual fund is reduced by the amount of the capital gain distribution. So net-net, you haven't gained anything other than a tax bill. According to the Investment Company Institute, in 2012, mutual funds distributed $99 billion in capital gains to shareholders.

Now, compare that with exchange traded funds (ETFs). If an ETF shareholder needs cash to purchase a house, they simply sell their shares through their broker or brokerage account with no impact to you. In other words, there's no need for an ETF manager (provider) to sell shares of stock held by the ETF to raise cash. The ETF structure itself also lends to greater tax efficiency. When ETF shares are created and redeemed, the underlying securities are delivered "in-kind". This means shares of the underlying stocks are exchanged for shares of the ETF (and vice versa) - there's no taxable event. A benefit of this process is that ETF providers can shed their lowest cost basis shares of stocks (which have the largest capital gains). There are instances where ETFs may reconstitute or rebalance holdings, thus generating a capital gain distribution, but those instances are rare. The bottom line is that with ETFs, you have significantly more control over when you realize taxes, as opposed to with mutual funds, where you're at the mercy of other shareholders.

In addition to ETFs providing you with more control over when you realize taxes, it's important to point out that another, more significant component of ETF tax efficiency is that most ETFs are passively managed. In other words, they simply track an index instead of paying a high priced manager to attempt to pick individual stocks for the fund (which, historically, they haven't been very good at - but that's a discussion for another time). This means lower turnover (less buying and selling) of the underlying stocks in the fund. And that means fewer taxable events. The below chart from Morningstar's "ETFs Under the Microscope: Tax Efficiency Survey" shows how capital gain distributions for actively managed mutual funds, passively managed mutual funds, and ETFs compare in the large blend category:

Also, consider that in 2012, iShares - by far the largest ETF provider, did not pay capital gain distributions on 98% of their 280 ETFs.

So, what can you do to protect more of your hard earned money from Uncle Sam? If you must buy a mutual fund, wait until after the fund pays out its capital gain distribution before you buy. You can generally check with the mutual fund provider website to find that date. If you already own a fund and it hasn't yet paid its capital gains distribution, you can avoid the distribution and still retain much of the performance of the fund by selling the fund and buying a highly correlated ETF that tracks the same or a similar benchmark. You can use ETF Database's mutual fund to ETF converter tool here to help you in that process. Finally, as the calendar turns to a new year, you might consider making ETFs a bigger part of your portfolio to minimize these headaches altogether.