While mutual funds are efficient vehicles for diversification, they’re sometimes not as efficient from a tax perspective. Investors often have questions related to capital gains, specifically associated with mutual fund activities. With 2020 being a volatile market year, here are the top three questions I’ve been asked and my insight into each.
Click or tap a question below or scroll to read the full list.
“What is a capital gain distribution, and why am I getting one if I didn’t sell any mutual funds?
Mutual funds are required by law to make distributions of at least 90% of capital gains incurred each year. First, some background on buying and selling of mutual funds. When an investor purchases shares of a mutual fund, it is not the same process as buying stock shares. A mutual fund transaction does not occur on an exchange, like the New York Stock Exchange. Mutual fund shares are purchased directly from the mutual fund company. Alternately, when shares of a fund are sold, they are not sold to a fellow investor. They are sold back to the mutual fund company. The fund companies’ responsibility is to account for the inflows and outflows of their funds and to have sufficient cash to meet their obligations.
Capital gains occur when a mutual fund manager sells a position within the fund at a profit. Managers may sell positions for several reasons. For example, during the year, managers may trim positions because they have grown in value, to reduce overall risk, or the manager believes the investment no longer makes sense.
Also, mutual funds need to meet redemption requests daily. When investors in a mutual fund sell their shares, the fund manager may need to sell positions to generate cash to meet the requests. In a volatile year like 2020, the manager may sell positions, incurring a gain that they would have preferred to avoid. Generally, investors should sit still during bouts of volatility. However, rash investors often panic, sell, then run and hide. Mutual fund managers are forced to sell to provide the liquidity needed to meet the panicky investors’ redemptions. Consequently, all investors who hold those mutual funds may receive larger capital gain distributions that year than expected. It is essential to understand that capital gains go to every investor proportionally, not just to the investors that sold their shares.
Lastly, some managers implement a high turnover strategy. They find value in buying and selling stocks with high frequency, regardless of the tax consequences. Funds with high turnover generally have more capital gains distributions.
“How does a long-term capital gain affect me?”
It depends. There is no impact on the owner of qualified accounts, like an IRA or 401(k). However, it does impact the taxable income of non-qualified account owners.
If you reinvest capital gains in tax-qualified retirement accounts, the distribution will immediately buy back into the mutual fund from where it came. Capital gains distributions not set to reinvest are paid out to cash inside your account. In essence, this is seen as a return of your invested money. No taxes are due on these retirement accounts until a distribution is made from the account, at which time they are taxed as ordinary income.
If your account is non-qualified, in that it does not qualify for preferential tax treatment, then you may have a tax liability for the year in which they occur. At this time, all capital gain distributions are treated as long-term capital gains, no matter how long you have held the investment. Generally, long-term capital gains tax rates are preferable to those of ordinary income. Please keep in mind that every investor is different, and I urge you to consult your tax professional regarding your situation.
“It looks like my investment went down in value. What happened?”
In this situation, it matters whether you reinvest capital gains or not. If you reinvest capital gains, when the mutual fund makes a capital gain distribution, the fund’s market value (the Net Asset Value, aka NAV) is reduced. Let’s use an example of a fund with a NAV of $50 per share and a capital gain distribution of $5 per share. The NAV declines by $5 to $45 per share. It may appear to be a decline in price; however, the total return of the fund has not changed. At this point, you will use the $5 per share distribution to purchase (reinvest) more shares of the fund at the new market price of $45 per share.
In the same example, if capital gains are not reinvested, the $5 per share distribution is paid in cash to your account. It is a return of a portion of your investment, not a reduction of its value. The remaining investment is valued at $45 per share and you will have the $5 per share value in your cash account.
Effectively, before the distribution, you had $50 of value per share owned. After the distribution, you still have the $50 of value, either in the mutual fund (after the distribution is used to purchase more shares) or as a combination of the fund worth $45 and cash worth $5 per share.
Timing also matters with capital gains distributions. In my experience, these distributions can occur on a Friday, and the corresponding reinvestment or cash distribution may not be reported until the next business day, Monday. This lag leaves a gap of a weekend for the process to complete.
Travis Crowell is a financial advisor with BFT Financial and is a graduate of Abilene Christian University with a degree in Financial Management.
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Mutual Funds are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing in Mutual Funds. The prospectus, which contains this and other information about the investment company, can be obtained directly from the Fund Company or your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.
Diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk.