Mutual Fund Capital Gains Taxes Could Be a Handful

After years of raging bull market conditions, many Americans will be sitting on large unrealized capital gains in their mutual fund portfolios.

That's a good thing, of course, but those gains do carry significant tax risks. And they are risks you can't necessarily control.

Capital gains taxation on individual stocks is simple and straightforward. If you own shares of Amazon.com (AMZN) or Tesla (TSLA), you will owe no taxes on your gains until you sell. And once you sell, the tax rate you pay on those capital gains will be determined by the length of time you held them and your income bracket.

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• If the shares have been held for over a year, you will owe taxes at the lower capital gains rate.
• If the shares have been held for a year or less, you owe the short-term rate, which is equal to your marginal tax rate.

Whether you pay taxes at all – and at what rate – is entirely up to you. You can hold the shares until you die, effectively kicking the tax can down the road to your children.

But this is not the case with mutual funds. While you might opt to buy and hold a mutual fund for the rest of your life, the trading decisions made by the manager will determine your tax liability. And that tax liability could be much larger than normal for the 2021 tax year, which you'll file in 2022.

That's because with mutual funds, capital gains flow through.

All About Capital Gains Distributions

Let's say you own those same shares of Amazon or Tesla in a mutual fund. When mutual funds sell stocks that have appreciated in value, and there are no capital losses to offset the gains, they are required to distribute those gains to the shareholders. You then have to pay taxes on the gains, whether you wanted to take them or not.

Capital gains distributions are usually paid out once per calendar year, generally in December.

And here's where it gets nasty.

Let's say you see a mutual fund you love, and you decide to buy shares today. Let's also assume that the mutual fund owned large positions in Amazon and Tesla that were up hundreds of percent after years of fantastic gains. (And remember: You just bought shares today, so you didn't get to participate in those Amazon and Tesla gains on the way up.)

Well, guess what? If the manager sells off some of that appreciated Amazon and Tesla stock the day after you buy shares of the fund, you're getting the capital gains tax distribution, meaning you're paying taxes on gains you never actually earned.

That's a raw deal. But there are some ways to mitigate it.

How to Reduce Mutual Fund Capital Gains Tax Liabilities

To start, to the extent you can, hold any and all mutual funds in an IRA, 401(k) or other tax-deferred account. Your capital gains distributions would have absolutely no consequences in that situation.

But let's say that's not an option. Or let's say you have extra cash to invest above and beyond what is available in your retirement accounts. You still have options.

Try to buy index mutual funds or ETFs instead of active mutual funds. Given the lower turnover of index funds, you're less likely to have the manager make gains-realizing sales. And ETFs add an even greater degree of protection in that investor redemptions don't create a need for asset sales. (ETF units can be created or destroyed based on investor demand.)

In the event you really want an active mutual fund, there is one final way to protect yourself: Avoid funds with high tax-cost ratios, which is how much the fund's annualized returns are reduced due to tax liability.

Mutual funds will provide information about estimated fund distributions, generally in November or early December. You can also use major reporting sites like Morningstar.

As an example, consider the Columbia Seligman Tech & Information Fund (SLMCX). Morningstar reports a tax-cost ratio of 2.64%, which is well above the 1.24% average for its category: large, blended funds. Another piece of data that Morningstar compiles is the Potential Capital Gains Exposure ratio. This is the percentage of the fund's assets that represent gains, as opposed to the original investment. In the case of the Columbia Seligman fund, that ratio is a full 62%.

Let's compare that to the Vanguard 500 Index Admiral Fund (VFIAX). The Vanguard fund also has a relatively high Potential Capital Gains Exposure ratio at 42%. But this exposure is never likely to be realized, as the Vanguard fund has exceptionally low turnover. The tax-cost ratio is a miniscule 0.43%.

Ultimately, taxes shouldn't be your biggest consideration. First and foremost, you should focus on earning good risk-adjusted returns. But taxes do indeed matter. So to the extent you can, try to avoid holding mutual funds with high potential tax liabilities in taxable accounts.