Never mind that this year has largely been a dud for stocks. A tax bill is still coming for many mutual-fund investors.
Now that December is here, funds are lining up to pass along something called a capital-gains distribution to their shareholders.
Investors who hold mutual funds outside a 401(k) or another tax-advantaged account must pay taxes on these distributions, even if they don’t sell any shares. And the bills could be big: More than a dozen funds have already said they expect to pass along distributions in coming weeks that are more than 30 percent of their total assets.
When a fund sells a stock, it records how much it made or lost on it. At the end of the year, it totals the gains it made from trading and distributes those gains to shareholders.
Say you hold a mutual fund whose shares currently trade at $10 each. That fund may distribute $2 per share in capital gains to you at the end of the year. You have to pay taxes on those gains if you hold the fund in a taxable account, even if you didn’t sell any shares. Long-term gains generally qualify for lower rates than short-term gains.
The value of your holdings won’t normally change as a result of the distribution, which often gets reinvested in the fund. The price of each fund share in this example would drop to $8 when it made the distribution of $2, leaving you with the same $10 per share.
Another reason for this year’s rise in distributions is the explosion in corporate takeovers.
Here are some other factors to keep in mind as distribution season approaches:
- Only investors in taxable accounts need to care. If all your funds are in an IRA, these distributions have no effect.
- If you’re looking to buy a fund at the end of the year, it can pay to wait. When a fund makes a distribution, it goes to all investors regardless of when they entered. Find out on funds’ websites when they plan to make distributions and wait until afterward to buy. The flip is also true: If you’re planning to sell a fund, do so before the distribution.
- Index funds can be more tax-efficient, but they’re not immune. Index funds generally buy and sell less often than actively managed funds, which means fewer opportunities to trigger capital gains. But even index funds and exchange-traded funds can pass along distributions. Some indexes are likely to have more turnover than others. A small-cap growth stock index will probably see its member list change more than a total stock-market index.
- Funds that go by the “tax-managed” label trade less often. They also may avoid stocks that pay dividends, because that income is taxable.