retirement

Hefty Fund Payouts Trigger Big Tax Hit

Investors have been socked with sizable taxable distributions in recent years, and 2018 will be no different.

This can be a taxing time of year for mutual fund investors. Toward the end of each year, mutual funds generally distribute to shareholders their net capital gains, or profits on the sale of fund holdings. If you hold funds in a taxable account, you will owe tax on those distributions—even if you reinvest them back in the fund. And if you buy into a fund just before a distribution, you will owe tax on gains you didn’t even receive.

Many funds have socked investors with sizable taxable distributions in recent years—and this year is likely to bring more of the same, fund analysts say. Two factors are supersizing the payouts. Thanks to years of strong stock market performance, many fund portfolios are full of appreciated holdings. What’s more, as the popularity of index-tracking funds soars, investors have been yanking money from actively managed funds. That can force fund managers to sell holdings to raise cash to meet investor redemptions, realizing gains that they must distribute to shareholders. Even worse, those gains are distributed over a smaller number of shareholders, increasing the tax pain for each investor remaining in the fund.

Fund payouts have soared in recent years as stocks marched higher. Mutual funds distributed $370 billion in capital gains to shareholders in 2017, up from $220 billion in 2016 and just $15 billion in 2009—the year stocks hit their financial-crisis nadir. Nearly half of 2017 distributions were paid to taxable household accounts, according to the Investment Company Institute, a fund-industry trade group. (If you hold funds in an IRA or other tax-advantaged account, the distributions don’t affect you.)

The gravity of a big capital-gains distribution depends in part on your tax bracket. In 2018, singles with income up to $38,600 and married couples filing jointly with income up to $77,200 don’t need to sweat it: Their capital-gains tax rate is 0%. Taxpayers with higher income, however, pay 15% or 20%.

Check fund-company websites now to find the date and estimated amount of year-end distributions. The estimates are often listed as a percentage of the fund’s current share price. A distribution amounting to 2% or 3% of the fund share price may not be worth getting excited about. A 20% or 30% distribution, however, is more painful—and could be a reminder to reassess the types of investments you hold in taxable accounts.

Dealing With a Hefty Payout From a Fund

Some funds have already announced that big distributions are coming at the end of this year. The Harbor International Fund, for example, said that it will make a mid December distribution of $21.50 to $23.50 per share, or 34% to 37% of the fund’s share price as of early October. That’s partly the result of a recent management change at the fund: The new managers sold off many holdings in order to shift the portfolio to their desired investments, Harbor said.

If you hold a fund that’s about to make a big payout, avoid investing additional money just before the distribution. You’d be taking a tax hit for gains that happened before your investment, says Jeff Tjornehoj, director of fund insights at financial-technology firm Broadridge.

Look to harvest losses elsewhere in your portfolio to offset the gain. “We go actively looking in those last two to three months of the year to take losses where possible,” says Lou Stanasolovich, chief executive officer of Legend Financial Advisors, in Pittsburgh. “But there aren’t many of them these days.”

Don’t rush to dump a fund just to avoid the distribution. If you’re a longtime shareholder, your cost basis in the fund may be well below your sale price—and the tax bill on that gain could be much bigger than the distribution tax bill you dodged. But if you were planning to sell the fund anyway—or trim your allocation because you’re rebalancing your portfolio—it may make sense to pull the trigger before the payout.

Longer term, tax-sensitive investors should consider keeping actively managed stock funds in tax-deferred accounts, Tjornehoj says. Reserve taxable accounts for index funds, exchange-traded funds and other more tax-efficient vehicles.

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