Episode 39
Understanding Capital Gains: What Mutual Fund Investors Need to Know

Table of Contents

• Introduction
• Summary of the Article
• Impact of Large Capital-Gains Distributions
• Factors Contributing to Capital-Gains Distributions
• How Investors Can Minimize Tax Impact
• Assessing Tax Consequences
• Considering Selling Before a Large Distribution
• Navigating Capital-Gains Distributions in New Investments
• Role of the Wash-Sale Rule
• Strategies for Tax-Loss Harvesting
• Conclusion

Introduction

Madison: Hello, everyone, and welcome to Not Just Numbers, Honest Conversations with a Financial Advisor and Lawyer. I am Madison Demora, and I’m here with Mike Garry. Mike is a financial advisor and a CFP practitioner and the founder and the CEO of Yardley Wealth Management. He is also an estate planning lawyer, and his law firm is Yardley Estate Planning. Hey, Mike.

Mike: Hey, Maddie. How are you?

Madison: I’m good, I’m good. How are you?

Mike: Pretty good, pretty good. Another beautiful day.

Summary of the Article

Madison: Yeah. All right, so today we are going to discuss an article from the Wall Street Journal, and it is titled, “These Mutual-Fund Holders Should Brace Themselves for a Big Tax Bill.” And this is by Daisy Maxey. This article we found, actually, at the end of last year, and it was Mike’s idea to hold it for around this time of year. So, do you want to explain why we decided to do that, Mike?

Mike: Sure. Thanks, Maddie. And thanks for holding it for this year and then reminding me that we said to do that. So we’re actually doing it. So, by the time we saw the article and our publishing schedule, it was too late to actually do anything about it. Like, we didn’t want to send it out after the end of the year because then it would be no good for our listeners. And so we decided to wait for this year. And then we have updated a couple things in it, and Maddie will have updated questions. And also, it’s a little bit touching for me. The article was written by Daisy Maxey, the Wall Street Journal. And 14 years ago this month, Daisy reached out, left me a voicemail asking if I wanted to be in the Advisor Outlook for 2011, if I would want to come to New York to be interviewed and be part of that for the Wall Street Journal. I thought I was being punked, and I was trying to think, who do I know that has a 212 area code? But it wound up being true. Daisy said they were just looking for somebody different from the people they’ve always had there. And her editor was a subscriber to our e-newsletter, and it was a great experience, a great time. And Daisy’s wonderful. So I’ll let you go back to the synopsis. Thanks, Maddie.

Madison: Yeah, sure. Thanks for sharing, Mike. So, I will read a summary like we usually do, and then I will go in and ask Mike some questions.

All right, so here is the summary:

The article discusses potential large capital-gains distributions in mutual funds held in taxable accounts, leading to tax implications for investors. Due to a shift to passive index funds, fund managers are selling winning holdings to meet redemptions, triggering distributions. While this year’s distributions are expected to be less severe than the previous year, some funds, such as Columbia Seligman Global Tech, Principal LargeCap Growth, and Russell Investment Multifactor US Equity, are set to make significant payouts. Investors can minimize the tax impact by checking distribution plans, considering tax consequences, and may opt to delay investments until after distributions to avoid immediate taxes. The article emphasizes the importance of investors being aware and taking proactive steps in managing the tax impact.

Impact of Large Capital-Gains Distributions

Madison: All right, Mike, so how do large capital-gains distributions in mutual funds impact investors, particularly those holding funds in taxable accounts?

Mike: Sure. So, when mutual funds and ETFs have to sell positions and record gains, they have to distribute those gains to their investors by the end of the taxable year. And so ETFs are generally a lot more tax-efficient than mutual funds because of their structure and how they handle those buys and sells. But mutual funds will have to pay out distributions. And if people are leaving the fund—which happens sometimes when stocks have a bad year or when the fund becomes unpopular—they sometimes have to make a lot of sales. And if the sales have gains, then those gains are taxable, and they could be short or long term, and they’re distributed usually in December. And it could be a real big tax hit for people that they don’t really expect.

One difference between holding, say, an individual stock and a mutual fund—in many ways, we prefer mutual funds versus individual stocks. But one way in which they are worse is that you can’t always control the taxes. If you buy an individual stock and it pays a dividend, sure, you might have tax on those dividends, but if you decide when to sell it for capital gains, that’s up to you. If you have a fund, they might have to sell positions for any number of reasons, and you’re going to have gains from that in addition to any gains that you would have from actually selling the fund. So they are totally outside your hand, and they can be quite large sometimes—we’ll get into that for this year.

Factors Contributing to Capital-Gains Distributions

Madison: Okay. All right. So, what factors contribute to fund managers being forced to sell winning holdings, triggering capital-gain distributions?

Mike: Yeah, it’s usually when the fund has become less popular and people are selling it, or when stocks go down any extended amount of time, people get nervous or frustrated, they sell. And so if there’s a lot of that selling, the fund has to raise cash to meet the distributions. And so, they may have to sell some of those winnings and distribute gains based on that.

How Investors Can Minimize Tax Impact

Madison: Okay, so how can investors minimize the tax impact of capital-gains distributions, and what proactive steps are recommended in the article?

Mike: Well, one thing would be to—if you like a fund and you know that it typically does pay big distributions, or you expect that it might—you could buy that in your IRA so that the taxability of the capital-gains distributions, they’re not taxed if you hold it in an IRA. The other thing you could do is you can sell other funds to take losses to offset the long-term capital gains.

The other thing we do is, if you really like a fund and you want to buy it, but it’s in the last quarter of the year, you could look to see if they’re going to be paying a distribution, and if it’s going to be a large distribution, wait till after the fund has made the distribution and then buy it then. Now, as the one guy—the advisor in the article—said, if it’s going to be a 1% distribution, I would just go ahead and buy it now, most likely, but if it’s going to be big, like 15 or 20%, then you would want to wait. And you can look those up a number of different ways, but I think we’ll talk about that a little bit later.

Assessing Tax Consequences

Madison: Yeah, sure. So, in what ways can investors assess the tax consequences of short or long-term capital-gains distributions in their mutual funds?

Mike: Yeah. So, most funds now have websites where you could go up, and fund companies will announce what they expect those distributions to be, usually by October. And so they’ll have estimates, and those estimates could be revised up or down. But you can look at your fund company or call investor relations if they don’t have anything on their website. And then we found this site, thanks to Daisy’s article, called Cap Gains Valet. And on that, it had funds that expect to pay out large capital-gains distributions. They had like 20% and 30% categories, and there’s already three funds in those categories. And it’s October 7th, so there could be a lot more coming, I guess.

Considering Selling Before a Large Distribution

Madison: Yeah, absolutely. Why might investors consider selling before a large distribution, and what factors should they weigh in making this decision?

Mike: Sure. So if the fund is going to make a 20% distribution, and say that the net asset value of the fund is $25 and they’re going to make a 20% distribution—if you buy that fund and are a holder of record when it makes a distribution, that 20%, or $5 per share tax hit, is something you’re going to pay taxes on even if you had no gains from the fund. Right? If you buy it on the record date or the day before the record date, and then it pays that, basically you’re just going to pay tax on things that you have not earned. Right? So nobody wants to do that. So you would wait until after the fund makes the distribution, and so then it makes that $5 per share distribution, then it becomes $20, and then you could buy more shares with the same amount of money and not have those embedded taxes for things that you got no benefit from.

Navigating Capital-Gains Distributions in New Investments

Madison: Yeah. How does the article advise investors to navigate potential capital-gains distributions when considering new investments in mutual funds?

Mike: Yeah. So take a look. If you are deploying money in your taxable account and it’s like October and November, look up your funds—the funds you’re interested in buying—before you do so to see if they have capital gains that they’re going to be distributing. Yeah. You don’t want to be caught holding the bag there—pay tax on something you got no benefit for.

Role of the Wash-Sale Rule

Madison: Yeah, absolutely. What role does the wash-sale rule play in the decision-making process for investors facing capital-gains distributions?

Mike: So it’s an interesting thing. So one person in the article suggested, if you’re going to have a big—if you’re going to get a big gain distribution on a fund that you have an unrealized loss in—so say you bought the fund at $30 a share, it’s trading at $25 a share, and they’re going to make a giant distribution, which is a terrible thing, right? That’s a bad position to be in—you could just sell the shares in advance. But remember the wash-sale rule: you can’t buy those same shares back for 30 days. You have to wait till the 31st day and then buy the shares back. Because if you sell something, take a loss, and then buy it back, the IRS will disallow that loss.

Strategies for Tax-Loss Harvesting

Madison: Okay. What strategies does the article suggest for tax-loss harvesting, and how can investors use this approach to offset capital gains in their portfolios?

Mike: Sure. You could do tax-loss harvesting. Basically, it’s like if you know you’re going to have gains, and say you still want to hold that position and it doesn’t make any sense for you to sell and harvest those losses, or you don’t have losses in it—you could look at other funds or stocks in your portfolio, in your taxable account, and sell them to take—if you have losses in them and you don’t necessarily want to have those holdings in the future—you could sell those to take the loss to offset the gains that you’d have coming from the mutual fund. And that sometimes makes sense.

Sometimes that’s a way for people to really clean up their portfolios. They’ll have some holdings that they have, and they’ve had them, and there’s maybe not really a good use for them, or maybe they’ve fallen out of favor. If you could help reduce your taxes, sometimes that helps people to go through the process of actually doing it—cleaning up that portfolio, taking the loss to offset gains on other holdings.

Conclusion

Madison: Okay. All right, Mike, is there anything else you would like to add to this episode?

Mike: No, no, this is good. Thanks again for saving this article for almost a year so we could go through it. But it’s a big deal. Like, if you have a brokerage account and you have a taxable account where you buy mutual funds or ETFs, it really does make sense—like before buying them at this time of year, take a look to see what capital-gains distributions, if any, funds are going to hand out, because it can really make a difference in your taxes and your investing experience for the year.

Madison: Yep, awesome. All right, so for more information on Yardley Wealth Management or Yardley Estate Planning, you can visit our websites at yardleywealth.net and yardleyestate.net. You can also follow us on socials at Yardley Wealth Management. If you are watching this on YouTube, don’t forget to smash the like button if you enjoyed this episode. This podcast has been produced by Madison Demora and Mike Garry with technical and artistic help from Poe Productions.