Mutual Funds’ dirty little secret….Capital Gains Tax

cap gains tax cartoonDear Mr. Market:

With one of the strongest stock market years on record many mutual fund investors will end the holiday season by unwrapping a lump of coal. In January most mutual fund companies and the IRS (Internal Revenue Service) will mail out Form 1099-DIV. 2013 will bring mutual fund investors capital gains distributions ranging from 6% to 60%. It’s no secret that we’re not fans of most mutual funds and capital gains distributions are just one more reason.  Today we will take a moment to address an issue that every investor (especially mutual fund investors) needs to be aware of – Capital Gains Distributions.

Capital Gains Distribution – The payment of proceeds prompted by a fund manager’s liquidation of underlying stocks and securities in a mutual fund. Capital gains distribution occurs when a mutual fund manager liquidates underlying positions that have made gains since they were added to the fund. Capital gains distributions will be taxed as capital gains to the person receiving the distribution. (Source –

 When a mutual fund sells any position at a profit it creates a capital gain, these can be either short-term or long-term.  By law mutual fund companies are required to distribute these gains to all of their shareholders.  If the position was held for less than a year it will be considered short-term. These are distributed to shareholder as income dividends and taxed at their ordinary income rates.  Long-term capital gain distributions (over one year) are taxed as follows: 0% for taxpayers in the 10% and 15% tax brackets, 20% for individuals in the 39.6% bracket and 15% for all others.  The key thing to remember when looking at mutual funds is that the investor has absolutely no say as to when positions are purchased or sold within the fund and the taxable consequences that are incurred.

Here is an example of how mutual funds distribute their Capital Gains to investors.  Let’s say an investor owns 1,000 shares of Super Return ABC Fund at $10 per share for a total investment of $10,000.  The fund announces that it will distribute a long-term capital gain of $1 per share.  All shareholders on the record date will receive $1 for each share they own and the NAV (Net Asset Value) of the fund will be reduced by $1 per share due to the distribution. If the investor chose to reinvest their dividends and capital gains then they would still have $10,000 but it would be structured with 1,111 shares at $9 per share.  If they received the distribution into their investment account they would have $9,000 in the fund and $1,000 in cash.

While investing and taxes certainly go hand in hand there are factors that investors need to consider.  How would the average investor feel if they received a negative return from a mutual fund for the year and had to pay taxes due to gains in bedded within the fund when they bought it?!  If you’re of the growing mind-set that 2014 could be the year when the market finally takes a huge breather and sells off…watch out! This potential situation is becoming more and more likely. If 2014 ends up being a bad (negative) year and your mutual fund didn’t distribute enough gains this year…guess when you’ll get the bill? That’s right…in 2014 and this is like “adding insult to injury”!

Here is an example that any investor needs to consider when looking at a mutual fund. We will use the example of the Super Return ABC Fund again.  Let’s assume that more than 20 years ago this fund bought the Microsoft IPO, a $500,000 investment grew to $500,000,000 creating a gain of $499,500,000!  Now the manager might have no intention of selling this position but if the market were to go through a correction or if investors sold their mutual fund shares the manager would need to raise cash to cover the liquidation requests.  If the Microsoft position were sold it would trigger huge capital gain liabilities.  Whether you had owned the fund for a few weeks or several years you would be paying for years of built up returns!

Do you own a Fidelity mutual fund? Take for example, Fidelity’s Magellan Fund (FMAGX). After a “great” year of +32% imagine the surprise from the Magellan shareholders after they were stung with a $5.52 per share capital gains distribution? That’s a massive increase from 2012, which was just $0.02. They’re not alone either; the Vanguard Group estimates most gains to be around 10% of net asset value this year. The Blackrock Capital Appreciation Fund (MDFGX) will distribute about 15% of its net asset value; add that to a front-end sales charge (load) of 5.25%, an expense ratio of 1.09%, and a paltry yield of 0.019% and it should make any informed investor question why they’re in such a trap.

Here are some things to consider when looking at purchasing a mutual fund:

  • Be careful when you buy shares of the mutual fund.  If you buy a fund on December 1st and the fund makes its year-end distribution on December 15th you will pay taxes.  Buy the shares after the fund makes its annual year end distributions.  Many funds will announce in October or November when they will be making distributions.
  • To avoid paying unnecessary taxes look for funds that have a low ‘turnover rate’.  This essentially means funds that are not buying and selling at a high level within the fund.
  • If you must own an actively traded mutual fund – own it in a qualified account (IRA, 401 (k))
  • Don’t fall in love with the historical returns of a fund– dig deeper and look at all the information – particularly tax liability. “What you see is NOT what you get”.
  • Finally, reassess why you even own a mutual fund in the first place. What if there were vehicles that charge fractions of the cost, are far more tax efficient, and outperform most mutual funds? There are…so feel free to ask us which ones compare best to what you currently own!

There are so many other factors to take into consideration when looking at a mutual fund.  If you find yourself overwhelmed then take the time to educate yourself or seek the help of a local fee-only financial advisor.  In this day and age there are so many investment vehicles to consider that might be a better fit for your personal situation. In summation, why ruin or dampen a great year of investment returns with a lump of coal that’s disguised as a standard part of mutual fund investing? Paying someone else’s taxes or more than what and when you should is simply an uniformed choice. You and your wallet deserve better than that…

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