Around this time of year, early to late December, mutual funds distribute their capital gains to fund shareholders. To the unitiated, this feels like a Christmas bounty. It's only later, around February of the following year, that shareholders receive their 1099s in the mail, detailing what part of the distribution was income and what part was a capital gain.
That's about when it dawns on many investors that they're going to owe Uncle Sam the 15% capital gains tax (for those in the 25% income tax bracket) on the amount of the capital gains. And, for those investors who have chosen to automatically reinvest all capital gains in new shares of the fund, they're stuck trying to figure out where to get the extra bucks to pay these extra taxes.
Why the Capital Gains this year, and why so big?
Funds might sell appreciated securities for various reasons.
1. Perhaps a stock hit management's sell target - not out of the question, given the ongoing strength in the 2009-2014 bull market - or a new manager came aboard and wanted to balance or rebalance the portfolio.
2. Or perhaps management had to liquidate positions to pay off departing shareholders (PIMCO comes to mind, having suffered outflows of over $32 billion in October alone).
Whatever the particular cause, if funds have sold appreciated securities during the year, by law, they have to distribute those capital gains to shareholders. If the shareholder owns the fund in a tax-deferred account, the distribution is a non-event from a tax standpoint. But if the investor owns the fund in a taxable account, he will owe capital gains taxes on these distributions. Those taxes will be due. Unfortunately, regardless of whether those gains were reinvested right back into the portfolio and even if the investor didn't sell a single share, those taxes are still due.
Let's examine this further:
Imagine the investor has a $100,000 stake in a mutual fund that makes a distribution equivalent to 12% of its net asset value. If this investor is in the 25% income tax bracket, he or she will owe 15% in capital gains on that $12,000 distribution, or $1,800.
As for single filers with taxable income up to $406,750 ($457,600 for married filing jointly), long-term capital gains or qualified dividend income over that threshold are now taxed at a rate of 20%. This high-earning investor would owe 20% in capital gains on that same $12,000 distribution, or a total of $2400.
Of course, a distribution in excess of 10% of NAV isn't an everyday occurrence. But in late 2014, five and a half years into the current bull market, a number of funds, some of them prominent, are about to pay out capital gains distributions in that neighborhood.
Here are capital gains estimates from a number of fund families (Note that these figures are all estimates; the actual percentage of NAV distributed will vary.) Many funds set to distribute large capital gains will translate into a significant tax hit for investors who hold sizable positions in taxable accounts.
The firm released updated capital gains distribution estimates on Nov. 24, and a handful of funds appear poised to make sizable distributions. The biggest distributions will come from:
Vanguard Explorer (VEXPX) (an anticipated distribution of 12.98% of NAV)
Mid-Cap Growth (VMGRX) (11.97% of NAV)
Vanguard Capital Value (VCVLX) has an estimated distribution of 9.22% of NAV.
A handful of Fidelity funds are estimating capital gains distributions in excess of 10% of NAV.
Fidelity International Small Cap (FISMX) (13.14% of NAV)
China Region (FHKCX) (12.25% of NAV)
Capital Appreciation (FDCAX) (10.13% of NAV)
Select Consumer Finance (FSVLX) (12.34% of NAV)
Select Environmental and Energy Portfolio (FSLEX) (12.02% of NAV)
Among the funds that the firm is anticipating will make the highest distributions are:
Growth Fund of America (AGTHX) (between 9% and 12% of NAV)
Investment Company of America (AIVSX) (between 8% and 11% of NAV)
SMALLCAP World (SMCWX) (between 9% and 11% of NAV)
T. Rowe Price
Among the big fund shops, T. Rowe had one of the longest lists of funds with estimated capital gains distributions in excess of 10% of NAV. They include:
Global Growth Stock (RPGEX) (11.3% of NAV)
Global Technology (PRGTX) (21.98% of NAV))
Health Sciences (PRHSX) (11.53% of NAV)
Latin America (PRLAX) (10.96% of NAV)
Mid-Cap Growth (RPMGX) (11.46% of NAV)
Mid-Cap Value (TRMCX) (12.07% of NAV)
New Era (PRNEX) (12.71% of NAV)
New America Growth (PRWAX) (12.78% of NAV)
New Horizons (PRNHX) (10.50% of NAV)
Science and Technology (PRSCX) (14.91% of NAV)
Here's the tax impact on the investor in the 25% income tax bracket:
New inflows into closed funds may not be substantial enough to match outflows, so management may have to sell shares to pay off departing shareholders. Those capital gains distributions, in turn, will need to be distributed across a smaller shareholder base making the tax impact even greater.
What To Do?
Unfortunately, there's not a lot that shareholders can do to avoid the blow. If you sell before a capital gains distribution you could trigger your own tax bill on the appreciation over your holding period. Instead, you might be best off paying attention to your fund's mailings to best know what sorts of distributions are coming so that you can try to reduce the tax impact.
New investors contemplating investment in a fund would be best off steering their investment into January of the following year. If he invests in December, before capital gains distributions are declared, the new investor will be stuck paying capital gains taxes on gains made before he became a shareholder. Here, timing is everything.
Perhaps you may be able to find losers elsewhere in your portfolio and sell those positions in order to offset the capital gain distributions from the funds. This is the art of tax loss harvesting.
Finally, the large number of funds making capital gains distributions in 2014 accentuates the value of asset location - making sure that you're placing tax-efficient assets inside of your taxable accounts and reserving less-tax-friendly ones for your tax-sheltered accounts, like your IRA or 401K.
This recent round of distributions points out that if investors want to help protect against unwanted distributions, and they insist on being invested in mutual funds, their best defense will be broad-market equity exchange-traded funds or index funds, which tend to distribute few, if any capital gains.
Capital gain distributions come to you automatically, anywhere from early to late December. And they're one of the worst parts of owning mutual funds.
If you have elected to automatically reinvest your distributions into new shares, as most investors do, you'll find yourself in a tight spot every April 15, wondering where you're going to get the scratch to pay these capital gains taxes on what seem to be phantom gains. If you've owned them for several years and you've built a large position, you could easily find yourself receiving tens of thousands of dollars of capital gains distributions each year, as shown in the above table, and owing many thousands in taxes. This is one of the ugly secrets of mutual fund investing that doesn't seem to dawn on most investors until they've been in them for some time. Longevity in these funds in your taxable accounts will require larger and larger amounts of cash flow from other sources to pay the tax bills every year.
Active investors can find a more tax efficient way
As a dividend growth investor for many years, I have found it to be much more tax efficient to choose individual companies that have strong fundamentals, have growing earnings, and long records of paying growing dividends over long periods of time, preferably 5 years or longer.
This allows complete control of the portfolio to be vested in me, rather than a fund's manager. This saves me the high management fees that, over time, will denigrate the capital value of a portfolio to a large degree.
This method also allows me to decide which equities to place in tax-deferred accounts, and which are placed in taxable accounts. It also affords me the ability to decide what I wish to sell, if I want to sell, and when. All of these independent functions constitute the control necessary to make the investor's portfolio as tax efficient as he chooses.
Any and all dividends received on equities sitting in regular tax-deferred retirement accounts will compound tax-deferred till they are withdrawn in RMDs when withdrawals are made in retirement. Capital gains will enjoy the same treatment. No current taxes will ever be due on these accounts until withdrawal. Those who have set up Roth IRAs will see their dividends and capital gains compound tax free all the while they are in these accounts, and also when they withdraw them at retirement.
As for equities in taxable accounts, no capital gains taxes will ever be due until and if the investor decides to sell the stock. If the investor never sells his stock, no capital gains will be due.
If the investor chooses to derive the benefits of receiving dividends and reinvesting those dividends, only those dividends will be taxable. Capital gains will continue to accrue untaxed.
I am well aware that some investors do not have the time nor the inclination to devote themselves to the pursuit of research to find suitable individual names for their own portfolios. For those investors, I would recommend the lowest-cost index funds, most of which distribute very little in the way of capital gains.
We are coming upon the time of year when these issues become top of mind. Stock shareholders begin considering whether they can or should conduct some tax loss harvesting in their portfolios, selling off their losers to reduce capital gains taxes on their sold winners that appreciated in value.
As for myself, I choose to be the captain of my own ship. I make the decisions; I choose how I get taxed, if I get taxed and if I have to share any with Uncle Sam. I find this to be much more tax efficient than being invested in mutual funds.
How about you? As always, I welcome your comments and look forward to a lively, civil discussion.
Should you be interested in reading any of my other articles detailing various strategies to enhance your returns on a dividend growth portfolio, please feel free to find them here.
Disclaimer: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks mentioned or recommended.
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Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.