02 10 2018

Why Mutual Fund Gains Can Bring a Tax Bill

Experts say the tax tail should not be allowed to wag the investing dog.

CONSIDER YOURSELF warned: Before making a large mutual fund investment this late in the year see if you would inherit a tax bill from a year-end capital gains distribution. You might avoid it by waiting.

It's standard advice to fund investors using taxable accounts. But conditions change and sometimes the danger is worse than others. So what's worth noting this year?

Mainly that stocks have been on the rise for so long that big distributions may be unavoidable for some funds. Fund managers who want to soften the blow by harvesting losses don't have many losing investments to sell, and many managers don't even try because most their shareholders use individual retirement accounts, 401(k)s and other tax-favored accounts and therefore don't pay this annual tax.

"With the continuance of the bull market many domestic equity funds have a sizable amount of embedded gains, which when distributed, can cause significant taxable issues for investors" holding shares in taxable accounts, says Paul Z. Shelton Jr., principal at Warwick Shore Advisors in Orlando, Florida.

"It is likely with the last couple years being good years that distributions will be bigger" than usual this year, adds Julia Carlson, founder of Financial Freedom Wealth Management Group in Newport, Oregon.

Year-end distributions are a common feature among actively managed mutual funds. Federal law requires that funds pay shareholders the net gains on assets the fund managers sold during the year. If the fund is held in a taxable account rather than an IRA or 401(k), the distribution is taxed as a capital gain, even if the payment is reinvested in the fund.

Purchasing a fund prone to big distribution late in the year means inheriting this tax bill for no good reason. That's because the cash from sales during the year is reflected in the share price when the fund is purchased. All else being equal, the share price will drop when the distribution is paid because that cash is no longer included in the fund's assets.

more: https://money.usnews.com/investing/funds/articles/2018-09-24/why-mutual-fund-gains-can-bring-a-tax-bill