Written by Alex Seleznev, MBA, CFP®, CFA | Dec 6, 2023
Imagine you've invested a substantial sum, let's say $100,000, in a mutual fund earlier this year. Despite the fund experiencing a 15% downturn for the year, you unexpectedly receive $20,000 in capital gains in December.
How is this possible?
Fund managers often need to generate cash to meet redemption requests from investors who sell their funds, possibly due to performance concerns. This often leads to capital gains that are then passed on to the remaining investors.
As one of the remaining fund shareholders, you will be responsible for paying taxes on both long- and short-term proceeds.
Who is at risk of receiving such distributions?
Investors who focus on actively managed mutual funds and keep them in taxable accounts, particularly those who have held onto funds for a long time or have inherited them, are most susceptible to this issue.
What can be done to reduce the impact in the short run?
If possible, consider harvesting tax losses to offset at least some of the potential capital gain distributions.
If you rely on your portfolio for income and need to raise more cash, consider waiting until the next year - you have less than four weeks to go - to limit your realized capital gains.
What can be done to avoid this issue in the long run?
The best practice is to plan ahead and keep funds with a history of large year-end capital gain distributions in tax-deferred accounts, such as an IRA or 401(k).
Explore using Exchange Traded Funds (ETFs) in your taxable account for their tax efficiency.
When investing in actively managed mutual funds, check the turnover ratio, which indicates the level of activity in the fund. A fund with a 30% turnover typically generates lower capital gains than one with a 70% turnover.
Funds that invest in smaller growth companies tend to trade more and, consequently, generate more taxable gains. Keep them in tax-deferred accounts.
Unfortunately, many individual investors and even some professional investment managers don't pay enough attention to the tax efficiency of their portfolios.
If your portfolio isn't invested tax efficiently, it may take several years to adjust it to a more optimal allocation. While it can be time-consuming, this effort can save you thousands in unnecessary taxes.
Remember, it pays to invest tax efficiently!