Most equity markets across the world continue to chug along hitting record highs seemingly multiple times every month.  Party time for mutual fund shareholders, right?  Well yes, of course it has been.  But there is a downside to these continued gains and that comes in the form of unexpected capital gain distributions (CGD) from mutual funds.  Note that these CGD are only relevant in taxable accounts (ie non-retirement vehicles).

Capital Gain What..??

By law mutual funds are required to distribute to shareholders most of the gains the fund realizes on the sale of their underlying investments. Those distributions are called CGD.  The distribution is then taxed to the shareholders on their tax return even if they simply chose to reinvest.  In most years, this is a mildly annoying additional source of taxable income. But after 8 years of continued market growth, funds find their portfolios awash in gains that must be passed on to shareholders.  

Several fund families are warning that their 2017 CGD will be in excess of 15% of the funds Net Asset Value (NAV).  For simplicity, assume the NAV is the current value of your holding in that fund.  For example, if a taxpayer owns $50,000 of Fund XYZ and that fund has a 15% CGD the taxpayer will have to pay tax on $7,500 of CGD.  That could increase the taxpayer’s tax burden significantly!

What Can I Do?

The obvious response is: “Well if the fund has capital gains then it is making me money!”. While true, it doesn’t make the sting of paying tax on that CGD any easier next April.  The reality is that there is not much mutual fund investors can do about these CGD.  But here are a few ideas to explore:

  • Many Exchange Traded Funds (ETF) are more tax efficient than typical mutual funds.  While ETFs do sometimes have CGD they are generally less frequent.
  • Index funds typically have less turnover and thus realize fewer gains than actively managed mutual funds, even in periods of rising markets.
  • Holding individual stocks eliminates the CGD problem entirely.

Note that none of the above investment vehicles eliminate capital gains taxes.  Rather, they provide the investor with more control over the type and timing of income they pay tax on.   

If you own mutual funds in a taxable account, you may have an unwelcome tax surprise this year.  Please contact us if you would like to discuss this further or would like a portfolio review to determine if your portfolio could be better aligned to reduce your annual tax bill.