The final months of the year are a good time to revisit your investments and rebalance your portfolio to bring it back in alignment with your long-term strategy and preferred level of risk.
However, if you’re looking to place some cash in a new mutual fund or ETF near year end, be careful not to make the mistake of “paying for someone else’s gains”, particularly in your taxable investment account. Here’s what we mean by that.
What are capital gains distributions?
Just as you’re rebalancing your portfolio, fund managers across the board also buy and sell assets to bring their respective funds back in line with an index or overall strategy benchmark. Those individual asset sales generate short- and long-term capital gains that funds are required to distribute to shareholders. Typically, those capital gains are distributed in December, but a handful of fund managers do it in November.
Now, if you purchase a fund in a taxable account just before capital gains are distributed, you’re going to be on the hook for taxes on those distributions from the get-go, even if you immediately reinvest them. In effect, you’re paying the capital gains taxes that accrued in that fund through the year, even though you may have only owned it for a few days or weeks — in effect, you’re paying taxes on gains you didn’t participate in. This is a common occurrence with mutual funds, but less so with ETFs as these funds rarely distribute capital gains. Funds with high turnover (managers who trade positions frequently) tend to generate more capital gains distributions than low turnover funds, for example.
This is an easy mistake to avoid, but it requires a little more diligence if you’re trading near the end of the year. Fund providers post the date of capital gains distributions and whether they will be long- or short-term. All you need to do is note that date and wait for the distribution to occur before purchasing. If you already own a fund that’s about to make a distribution, check your gain or loss. If you are holding it at a loss, or at a gain that is much lower than the expected distribution, you may consider selling it prior to the distribution if you intended to already. If you’re working with a financial advisor, they’ll have already taken capital gains considerations into account before moving money into or out of a fund for you. They may even recommend funds with low turnover to avoid sizable taxable distributions in the first place.
If you’re managing investments in a tax-deferred account, such as a 401(k), you don’t have to worry about the annual tax implications of fund distributions (that’s the big advantage of these accounts). However, keep in mind the NAV, or share price, of a fund will drop by the amount of the distribution when it occurs. You might see a sharp sell-off in the fund on the distribution date, but that’s simply because it made a distribution.
Mutual fund distributions are just one of many tax considerations in a financial plan, which is why it can be helpful to work with financial advisor or tax attorney to ensure you don’t end up paying Uncle Sam more than necessary.
This material is not intended as legal or tax advice. Financial Representatives do not give legal or tax advice. Taxpayers should refer to an independent tax or legal advisor.