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A Taxing Situation

Richard Connor

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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