Sep 17, 2019

Capital Gains Distributions from Mutual Funds – a Silver Lining?

As we are nearing the end of the year, mutual fund companies will soon be releasing estimates on capital gains distributions within their various fund offerings. For owners of mutual funds in non-qualified accounts, these distributions will result in taxable gains at current capital gains rates of 0-20% depending upon tax bracket.

The negative aspect of this event is pretty obvious – nobody likes paying taxes. But, is there a positive to be found in a capital gain? Perhaps so.

First off, capital gains are created when a fund manager decides to sell a stock within the fund. This is often a sign that the manager feels the stock has reached a price level where it is unlikely gains will continue to be made. Unlike an index fund, the advantage of an actively managed portfolio is that there is ongoing analysis of each holding and decisions made whether to keep or sell. In a protracted positive market like the one we’ve experienced in this cycle, there is a point where even very successful investments reach an unreasonable price point. Since the objective is to make money, a capital gain is a sign of a successful investment.

Secondly, though capital gains are taxable, each gain raises the tax basis of the fund. This allows the fund owner to pay a small portion of their taxes on gains each year. When the fund is ultimately sold, the net gain is much less; you’ve essentially prepaid your tax. And if you sell the fund for a loss, you’ll get a refund for taxes already paid. A person might argue that individual stock investors have the advantage since no taxes are paid till the stock is sold thus delaying any tax paid. However, this ignores the benefit of capital gains reinvestment. Fund owners can reinvest capital gains to buy more shares, enabling them to compound their growth more effectively. In a volatile market, this allows a fund holder to benefit in times of market weakness.

In considering ways to lessen the effects of capital gains, consider tax loss harvesting. If you have a fund that has experienced a loss, consider a sale and replacement with a similar, though not identical fund. As long as the previously sold fund was not purchased in the 30 days prior to the sale date and is not re-purchased 30 days after the trade date, the sale will not violate the “wash sale” rules. Additionally, even funds that have an overall gain may have particular lots that have embedded losses. Those lots could be sold as well in a process called “specific lot” harvesting.

Overall, nobody likes paying taxes, but keep in mind, the ultimate goal is to make money. A capital gain is one of the signs that you are on the right track.

 

Investors should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. This and other information can be found in the prospectus or summary prospectus. A prospectus or summary prospectus may be obtained from your financial advisor. Please read the prospectus or summary prospectus carefully before investing.

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