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Where It Nets Out

Matt Halperin

I SOLD A MUTUAL FUND in my taxable account that was up an average 6% a year over the past 10 years—and ended up with a tax loss. That’s right, I took a loss on this international fund, even though it had returned 6% a year. How does that happen?

Suppose you bought one share of a mutual fund for $12 on Jan. 3. Over the course of the year, the fund’s investments fare well. On Nov. 15, the fund’s shares are worth $14. The manager sells the fund’s winners at a profit. The fund’s shares are still worth $14, but now—instead of the winning stocks—the fund has the cash from selling those investments.

On Nov. 30, the manager declares a $4 capital-gains distribution, payable on Dec. 1. On Dec. 2, the fund’s shares are now worth $10 and you have a check for $4. All told, you still have $14. If you sell the fund on Dec. 2, you’ll realize $10, less than your $12 purchase price. You’ll take a loss of $2, even though your pretax wealth has increased by $2.

All is good—until tax time. That’s when you’ll report the $4 capital-gains distribution that’ll be shown on Form 1099-DIV. The manager reports that the distribution includes $2 in short-term gains and $2 in long-term gains. How can you receive long-term gains when you only owned the fund for 11 months? Whether they’re long-term or short-term gains will be based on when the fund bought the stocks that it sold.

Meanwhile, you will take a $2 loss for selling the fund, which you bought for $12 and sold for $10. Netting all this out, you pay tax on a long-term gain of $2. In effect, your tax bill as a fund shareholder depends not only on the fund manager’s actions, but also on your decision to sell the fund.

IRS rules require mutual funds to distribute 95% of their net income and realized capital gains each year. Funds are pass-through structures for tax purposes. A mutual fund itself doesn’t pay any taxes. Instead, gains and dividends flow through to the fund’s shareholders.

When I started saving 30 years ago, I found dividend reinvestment plans (DRIPs) to be a simple and efficient means to amass shares of individual stocks, including by reinvesting dividends. DRIPs offered low costs and the ability to buy a fraction of a share. Similarly, mutual funds allowed me to reinvest dividends and capital gains with no minimums.

Since then, the cost of investing has dropped and I’ve become more tax sensitive, leading me to invest more in index funds. They have lower turnover, meaning they’re slower to sell their winners, plus they have other methods of reducing their capital-gains distributions.

What do you do if you have a capital gain on a fund that you’d like to sell because it isn’t tax-efficient? First, check that you really have a taxable gain with the fund, by making sure you’re calculating your cost basis correctly. That cost basis would include both your investments in the fund and any distributions that you reinvested in additional fund shares. Funds and brokers have only been required to keep track of an investor’s cost basis since 2010. Their reported number may be different from your actual cost basis.

Next, stop reinvesting fund distributions. Instead, direct those distributions to a more tax-efficient fund.

What if you really want active management? Ideally, you’d invest with the active manager through your IRA. What if you’re considering buying an actively managed fund in your taxable account? Look at the fund’s embedded gains. These are the unrealized gains that will be realized if the manager sells. A fund’s annual report will include information on unrealized gains. Compare these unrealized gains to the fund’s total assets to see how significant they are.

A final tip: If you’re purchasing index mutual funds in your taxable account, look to invest in a fund that has a companion exchange-traded fund—a so-called dual-share-class fund. These funds tend to be especially tax-efficient. Vanguard Group owned a patent on this structure that recently expired, so other managers are now creating dual-class funds, including Morgan Stanley and Fidelity Investments.

Matt Halperin, CFA, is the founder of Act2 Financial, an app that helps seniors avoid financial fraud. For 30 years, he worked as a portfolio manager and risk manager at large U.S. money managers. Matt currently serves on the investment committee of two endowments.  He has a BA and MBA from the University of Chicago, and resides outside of Boston.

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