Every December, as people all over the world pick out gifts for their loved ones, the mutual fund companies are busy planning a surprise of their own. Capital gains distributions! For every fund share that you own, your mutual fund company will distribute to you a portion of the capital gains that the fund has incurred during the year, if any.
Sounds great, right? Everyone loves gains. However, it’s quite possible that you personally do not have much of a gain on your investment. It’s even possible that you’ve recently bought into the fund and have no gains at all. Doesn’t make a difference, if you own the fund, you’re getting a distribution.
And get your stockings ready, because this December the funds are planning to be extra generous. A long rally combined with selloffs in August and October means that many funds have had to cash in winners this year. That translates into big year-end distributions, and a Santa-sized tax bill for you in April.
Those are some big percentages. But if these are not all your gains being distributed, whose gains are they? They actually belong to investors in the fund from earlier years, some of whom have already cashed out. The fund was able to support their redemptions by selling holdings that were flat or at a loss, while retaining positions with embedded gains.
In the early years of the post ’08-’09 meltdown, it was easy to sell losers to free up cash. That quickly got more challenging as the rally continued. Now, five years into a bull market, the mutual funds find themselves with almost no losers left to sell. Most every equity fund is larded up with gains. They now have no choice but to pass them on to you.
Still don’t care? The trouble with receiving gains is that unless you hold these funds in an IRA or 401k, you will be forced to pay taxes on the distribution. Even worse, if the distribution includes short-term gains, you’ll have to pay ordinary income rates even if you’ve owned the fund since the 80’s! It drives home the fact that you’re stuck in a pool of stocks, and you are responsible for anything that has happened in that pool during the year, regardless of when you bought in.
As a comparison, consider shopping for a condo. I did this recently, so it’s fresh in my mind. One of the major things to watch out for is a condo association with inadequate reserves. The reserves are money paid into the condo association against the chance that there is a big upgrade or fix needed. If reserves are inadequate when an expensive project comes along, every condo owner gets a “special assessment,” and has to chip in to foot the bill. This assessment is due even if you’ve recently bought your condo and haven’t yet enjoyed any of the benefits of the association. While it’s not a perfect analogy, I’m sure you can see the connection. The previous owners of your mutual fund have depleted its reserves, and now you are on the hook. Not fun.
However, new mutual fund owners have an easier escape than do condo owners. Sell the fund! If you don’t have a big embedded gain, why pay capital gains tax? It makes no sense. If you’re at a loss, you can buy into another similar fund for 30 days (or better yet, an index ETF) and claim the loss on your taxes. If you love the fund, buy back in after the distribution.
Index ETFs > Mutual Funds
To be fair, index ETFs are not exempt from the capital gains issue, but they are at a large advantage. There are a couple reasons why.
1) Structure. While mutual funds must sell stocks for every redemption request, ETFs are able to redeem shares “in kind” if the redemption blocks are large enough. This means that they can distribute shares directly, and pass on the embedded capital gains.
2) Passive management. Index ETFs are passive, meaning they track an index instead of actively making bets on the market. Because indices do not change very often, index ETFs suffer very little turnover in their portfolios.
Put these two reasons together and you have an investment option that is tax efficient, and cheaper overall than the typical actively managed fund.
The tax suffering caused by end-of-year distributions is just one of the reasons why Personal Capital avoids mutual funds in client portfolios. These funds have an inefficient and antiquated structure, and are often combined with high fees and lagging performance. If you haven’t already done so, check out your Personal Capital dashboard to view your mutual fund fees.
The results may surprise you! And if you’ve been on the fence about getting rid of that high-fee fund in your taxable account, let the looming 2014 capital gains distributions provide that last needed push.
For the holidays this year, allow the mutual funds to bestow their gifts on someone else. You won’t miss them.