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MUTUAL FUNDS ARE about to send their shareholders some dubious holiday gifts—in the guise of capital gains distributions. These distributions usually occur mid-December and they represent a taxable event for investors who hold funds in a taxable account.
Even in a down year for stocks and bonds, a mutual fund may realize capital gains, which are then passed on to shareholders. These could come as a nasty surprise to investors already smarting from 2022’s steep losses.
It seems counterintuitive that a fund that lost money could also produce taxable gains. How can that happen? Throughout the year, a fund trades stocks, and its stock sales will result in a gain or a loss for the fund. The accumulated net gain—if there is one—is then passed on to the fund’s shareholders. A fund’s share price will drop by an amount equal to the distribution, so shareholders are no better off—before factoring in taxes. The problem: If you hold the fund in a taxable account, you’ll be responsible for paying taxes on your share of the fund’s net capital gain. A fund’s long-term winners are taxable for shareholders at the lower capital gains rate, while short-term capital gains are taxed as ordinary income.
This year, many investors appear to have sold their actively managed funds. These sales force a fund’s manager to sell stocks to generate the cash needed to pay off departing shareholders. That creates a tax conundrum, because many funds hold stocks that enjoyed significant gains in 2020 and 2021. Selling these appreciated assets produces a capital gain. The fund can offset these gains by selling stocks at a loss. But as more people bail out of a fund, the manager may run out of losses to realize and instead must sell winners to generate cash.
Mutual funds typically provide an estimate of their expected distributions in October or early November. Vanguard Group estimated its mutual fund distributions as of Oct. 31. It plans to provide final estimates on Dec. 8.
For example, as of a month ago, the estimate for Vanguard’s popular Windsor fund (symbol: VWNEX) was $9.82 per share, or 12.8% of the share’s net asset value (NAV). Through yesterday, the fund was down 1% in 2022, a nice recovery after being down almost 18% as of September.
More painfully, Vanguard’s International Growth Fund (VWILX), currently down 28% year-to-date, is estimated to pay a $4.92 per share capital gains distribution, or 5.6% of NAV. To an investor, this is a double shot of pain—both a loss for 2022 and an unexpected tax bill.
Is there anything you can do? The first step is to do your research and find out if you own a fund that’s planning to make a big capital gains distribution. Then find out the record date. That’s the date that the investment company uses to determine who’ll receive the distribution. Vanguard publishes its fund record dates here.
For instance, Vanguard International Growth’s record date is Dec. 13. If you sell your position prior to that date, you’ll avoid the taxable capital gains distribution, while also potentially locking in a tax loss. You could then invest the sale proceeds in a fund that gives you exposure to the same market segment, such as Vanguard Total International Stock Index Fund (VTIAX), which is down 15% year-to-date and has a low 0.11% expense ratio.
But before you sell your position, check your cost basis on the shares. If you’ve owned the fund for a while, you may have a large unrealized gain, despite this year’s market losses. In other words, selling your shares to avoid a taxable distribution could trigger a capital gain—and that taxable gain could be larger than the year-end distribution you’re trying to avoid.
If you choose to sell a position and reinvest in a similar fund, be aware of the wash-sale rule. This rule prevents you from utilizing the tax loss if you invest in a “substantially similar” asset within 30 days of the sale. Morningstar published an article recently with some great suggestions of quality, tax-efficient funds that should meet most investors’ needs.
If lots of investors sell stock funds ahead of this year’s capital gains distributions, it could have a knock-on effect, making the situation even worse. How so? By selling, departing shareholders could force a fund to unload yet more appreciated securities and they might cause the number of fund shares outstanding to shrink—and that could mean an even bigger capital gains tax bill for the investors who remain.
Richard Connor is a semi-retired aerospace engineer with a keen interest in finance. He enjoys a wide variety of other interests, including chasing grandkids, space, sports, travel, winemaking and reading. Follow Rick on Twitter @RConnor609 and check out his earlier articles.
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Richard, I have vague memory of reading about this topic of end of year capital gains distributions before, and one of the take home points (I think) was that for an account that is NOT a tax-sheltered retirement account: “If you buy into a fund just before its end of year capital gains distribution you may end up paying tax on gains you never saw yourself”. Am I remembering that correctly (or am I confused)? If correct, then should a single purchase into such a fund be avoided late in the calendar year, especially if substantial? Thanks. And THANKS to all the HD writers and commenters for the lessons I am learning!
If you buy into a stock fund late in the year, there’s definitely a chance you’ll “buy a distribution.” That shouldn’t stop someone from making a regular monthly investment, but it would be a reason to check before investing a large sum.
another option for appreciated shares of actively managed funds in taxable accounts is to donate them. potential triple tax benefit by avoiding large year-end taxable distributions, not realizing capital gains that would occur by selling, and getting itemized deduction.
Really helpful article, Rick. I am curious where to get more information on the wash rule. In 2023 I plan to consolidate my various index funds (Vanguard Growth, Vanguard Value, etc.) into the Vanguard Total Stock Market Index Fund, but am concerned that moving funds from VFTAX (Vanguard FTSE Social Index Fund) might be a problem, as it is a lot like the S&P 500 index funds in portfolio distribution. Anyone have insights?
Most of the material I’ve read says the IRS won’t bother you about that. ESG and a broad market index fund are different enough to not trigger a wash sale. However, you may want to do some moving this year if you can balance gains with losses.
Rick,
For taxable mutual fund holdings that have multiple purchases or reinvestments over many years, consider using the specific identification method, i.e., selling those tax lots that have losses – in place of the default average cost method. One should generally notify the custodian of the method employed before or upon sale.
Vanguard International Growth Fund (VWILX) shares purchased prior to 2019, for example, may still have unrealized gains. Shares acquired through purchases or reinvestment since 2019 may have unrealized losses. One might choose to sell only the more recently acquired VWILX shares that have unrealized losses.
Good point about turning off the automatic reinvestment if one does not sell all holdings in a fund.
Thanks for writing the column and alerting readers to the strategy to harvest losses and avoid gains from LTCG distributions.
And thanks, Adam, for suggesting that HumbleDollar tackle the topic. For others reading this: The idea for Rick’s article originated with an email that Adam sent me last week.
What a helpful article. I wish I had seen this years ago when questions about mutual fund distributions were never sufficiently answered.
Caution: As Rick notes, the wash sale rule is “within 30 days.” It goes both ways, 30 days before and after. So if your holding issued a dividend within the 30 days prior to you selling, and that dividend was reinvested, that creates a wash sale.
Thank you for a “well rounded” article on this subject. Other, recent articles on this topic were written as if everyone reading it has more money than they know what to do with and plagued with being in the highest tax brackets.
In fact, a big “Thank You” to all who contribute to and operate humbledollar.com. As a recent retiree off to a rough start, this site has been very helpful in more ways than I can mention. Very helpful perspectives presented here that help in thinking through issues in a more balanced way. Not a social media user but great to find a site and users that are more focused on helping people rather than trying to slam others they don’t agree with.
Best wishes to all for good health, comfort and joy through the coming Holidays and the years ahead.
I’m so glad you find the site helpful. As you indicate, one of HumbleDollar’s strengths is the fairly civil discourse in the comment section — and I’m grateful to the readers who have kept it that way.
“More painfully, Vanguard’s International Growth Fund (VWILX), currently down 28% year-to-date…”
Alas, I own some of this beaten down fund in my taxable account. However, my buy-and-hold (“inertia”) investment habit seems to be limiting losses, as you mention above on checking cost basis. In this instance, a tax loss harvest from selling and moving the remains to another fund would barely cover dinner out with my kids out for pizza and sodas.
I guess I’ll take the distribution, which will be reinvested to buy more of this holding at its current battered price. Maybe next year it’ll do better.
So far in my investing life, every sub-par holding I have sold off has turned around shortly afterwards. As a result, dollars from any fund I exit these days goes into a total market index. I’ve lost interest in trying to outsmart the sum of the market anymore.
: )
If you’re not happy with the fund, don’t buy more–turn off your automatic reinvestment.
Thanks for this. I checked the Vanguard estimated distributions link and it looks as if none of the funds in my taxable account will have capital gains. I own VGHAX, but it’s in my Roth.
Am i missing something that sooner or later, one way or another taxes will be paid. It’s a matter of timing.
Taxes will always be paid, but it’s generally better to know you owe them before hand, and do some planning if possible. I think it’s also good to know what kind of fund you own. A year end review may let you know you’re invested in something you don’t want to be invested in.
As a rule, it’s always better to pay taxes later, because in the meantime you get to use the money earmarked for Uncle Sam to earn extra gains for yourself. On top of that, of course, if you hold a fund until death, your heirs will benefit from the step up in basis and the embedded capital gains tax bill will disappear.
In addition to those smart things you talked about, there is one more thing investors should do if taxes are so concerning to them. Sell their mutual funds and buy ETFs for those who are tax sensitive because much of their assets are in taxable accounts. ETFs are more tax efficient. People have been doing this as evidenced by the fact that global ETF assets have gone from 8 to 9 trillion $ in 2022.
I believe that it has been mentioned before on HD that Vanguard allows a tax free conversion from their mutual fund shares to an equivalent value of ETF shares. This will avoid all capital gains distribution related income taxes. (There are still dividend distributions.) In Vanguard’s case the MF & ETF shares are different share classes of the same investment. I don’t know whether this option may apply to other investment firms.
I’m not sure how significant the oft-touted ETF advantage is.
I know ETFs are usually more tax efficient, but this is often because they happen to be index funds, not because they’re ETFs.
I realize ETFs do have their own tax efficient characteristics, whether index funds or not, because of how they can avoid distributing capital gains.
I think most of the advantage comes from the former, and there are ETF negatives to consider such as taking longer to settle, and the preference to trade them while the market is open, and particularly not too close to market open and close, per advice from Morningstar. The same Morningstar article suggested if you don’t need to trade during the day, you’re probably better off with traditional funds.
I’m all about increasing tax efficiency, but also about simplifying the portfolio and its management, so am undecided about whether increasing index holdings will be in traditional funds or ETFs.
Peter, thanks for the great point. The Morningstar article I referenced includes some tax efficient ETFs.