Year End Tax Tips For Mutual Fund Owners

You might see some very strange things going on with your mutual funds in November and December. That’s the time when many funds distribute capital gains and dividends. Investors get befuddled by this because they can wind up paying taxes on money they may not even receive.

Worse, people sometimes have to pay capital gains taxes even when their fund losses money. Let’s explore how mutual funds are taxed and then discuss what you can do about it.

How Funds Are Taxed

There are three events that can trigger income taxes for mutual fund owners. Let’s go through each one.

The first is capital gains distributions. During the year the fund manager buys and sells it’s holdings. If at the end of the year he or she made a net gain on those transactions the fund will have a capital gain to report. Your share of those gains is taxable even if you reinvest those gains. Sorry friend.

(If the fund reports a net loss on those transactions you don’t get to report the loss on your return but the fund manager will use those losses to offset future gains. You’ll have to be patient.)

When a fund declares a capital gain the fund price drops. This may make you a little uneasy but it’s absolutely nothing to worry about and I’ll show you why.

Let’s say Fund XYZ shares are currently traded at $10.00 a share and they declare a $1 a share capital gain. That $1 represents your share of the realized profits they made from buying and selling during the year. On the day they distribute that capital gain, the value of the share will drop by $1 (assuming the price of securities held within the fund don’t move that day). Here’s why.

Before they declare the capital gain, that $1 is in the hands of the fund. But when they pay out the gain, the money gets distributed to the shareholders. At the point, the assets held by the fund drops by $1 for every share in the fund. Simple.

The fund holder can take that $1 capital gain per share and buy more shares of course. If you had 100 shares of this fund before the capital gain distribution you’ll receive $100 as a taxable gain. Assuming the market is completely flat the day this happens, the price per share will drop by $1 so you can take your $100 and buy 11.11 shares at $9 per share.  Before they declared the gain you had 100 shares valued at $10 per share or $1000 worth of shares. Now you have 111.11 shares valued at $9 per share. That also equals $1000. You see….your situation hasn’t really changed too much.

The only difference is that while you used to have $1000 in value with no tax liability now you have $1,000 and owe tax on $100. This stinks but it is the way the IRS wants it so that’s the way it is.  (These distributions are taxed either as long or short term depending on how long the fund held the securities rather than how long you held the shares.)

If that wasn’t bad enough, there are two additional ways your mutual funds are taxed.  If your fund pays dividends they are also taxable income even if you reinvest the money. And you can also incur taxes if you sell your shares at a gain during the year.

What You Can Do About Mutual Fund Taxes

Nobody likes to pay taxes. Fortunately there are a few tactics you can use to reduce or avoid taxes on your funds:

1. Be Careful When You Buy Funds

If you buy a fund today and it distributes a capital gain tomorrow, you won’t make any additional profit – that profit was already made throughout the year.  But you will have to pay income tax on those gains. Bummer.

You can minimize that problem by simply not buying funds that are about to declare a large gain. Make sure to do a little research and find out when the fund is planning to declare any taxable distributions before you push that “buy” button.  This is especially important around this time of year.

2. Take The Money

If the IRS is going to tax you on a gain you might want to take that gain and use part of the proceeds to pay the tax. You’ll compound your growth a little slower but at least you won’t be fund rich and cash poor.

3. Sell The Fund After The Gains Are Declared

Consider the example I proposed above. Let’s say you bought 100 shares of that fun 10 a share and they declare a capital gain of $1 per share the next day. You now own 111.11 at $9 per share but have a $100 taxable gain. But here’s the good news; your cost basis rises to $1100 when you reinvest those gains.

If you then sell your 111.11 shares at $9 per share, you’ll receive $1000 and that means you’ll create a tax loss of $100 because your cost basis is $1100. This cancels out your gain and the only one who losses is Mr. Grumpy IRS. Who cares?
You can wait 31 days and buy the same fund (to avoid the wash sales rules) or buy a different fund that has similar attributes. Either way, you’re in good shape.

4. Harvest Losses – Especially Short-Term Losses

If you have an investment advisor, ask them for a partial realized gain and loss report in November. This will show you how much tax exposure you face and it will also tell you if you are sitting on any losses that you can sell to neutralize your gains.

If you are a DIY investor, make sure you use a broker that supplies these reports. Identify those funds that can be sold at a loss to offset gains and then replace those funds.

5. Don’t Worry About It

Mutual fund gains are a nuisance but as long as you don’t buy a fund that is just about to declare a big gain, taxes on funds shouldn’t be a major concern for you. Some people only buy ETFs because they are less expensive and usually subject investors to no or low gains until they sell their shares.  That’s not bad of course but if it comes at the cost of bad performance it may not be worth it.

When it comes to mutual funds, first take a little time to understand how they are taxed. Next, understand that if your fund takes a big dive overnight, it may be a result of a capital gains distribution. Last, remember there are always a few tricks up your sleeve to mitigate these problems. You can use tax loss harvesting and you can be mindful about when you buy those funds to reduce or eliminate the problem altogether.

Personally, I don’t find taxes on mutual funds to be much of a problem. Do you? If so…why?  What other year-end tax moves are you making?