Stop the Mutual Fund Capital Gains Distribution Madness!
Some funds are likely to make big payouts again this year, but you don't have to take them lying down.
When I joined Morningstar’s fund analyst team more than 20 years ago, we’d sometimes talk about various actively managed mutual funds being tax-efficient, largely because they didn’t trade a lot. Third Avenue Value (TAVFX) used to come up in this context; BNY Mellon Appreciation (DGAGX) was another.
Yet even as low turnover should, in theory, contribute to good tax efficiency because it limits the manager’s realization of taxable capital gains, the data continue to pile up to demonstrate that the vast majority of active funds just aren’t a good bet for taxable accounts.
That’s because a manager’s decision to stand pat with his or her holdings isn’t the only factor driving turnover and, in turn, capital gains distributions. As we’ve seen in stark relief over the past decade, investor selling can force management’s hand, prompting sales of stock that he or she might otherwise like to keep.
Sequoia Fund (SEQUX) is the best recent example I can think of. The fund’s managers always employed a patient, low-turnover approach. Although the fund was closed, which tends to crimp tax efficiency because assets can leave more readily than they can come in, the fund managed to limit taxable capital gains distributions. That all changed starting in 2015, when Valeant Pharmaceuticals (now Bausch Health (BHC)), the fund’s top holding at nearly 30% of assets, fell sharply. The fund posted losses in 2015 and 2016, shareholders hit the exits, and the fund’s once-solid record of limiting capital gains distributions fell by the wayside. After paying out enormous distributions from 2016 through 2018, the fund’s three-year tax-cost ratio is an enormous 3.39%. That means that shareholders in the highest tax brackets who hold the fund in taxable accounts have ceded about a fourth of their 13% three-year annualized return to taxes.
Of course, capital gain distributions and tax-cost ratios are irrelevant if you own a fund in a tax-sheltered account like an IRA or a 401(k). You won't be paying taxes on capital gains distributions that occur as the years go by, provided your money remains within the confines of that account; you'll only owe taxes when you cash out, and those taxes will be based on your total appreciation, not on these year-to-year distributions. Thus, to the extent that you own active funds in your portfolio, your tax-sheltered accounts are a good spot to hold them.
Most funds have not been tax-efficiency disasters. Nonetheless, the combination of a strong market environment and investors’ shift into low-cost passive investment options has forced sizable capital gains distributions at many funds in recent years. I’ve been monitoring these distributions each December; here's the 2018 compendium. There’s little reason to believe that the 2019 distribution season will look a whole lot different: Not only have investment returns been strong but some of the same active-fund categories that have posted strong gains have also continued to see shareholder redemptions, which force managers out of appreciated positions, unlocking capital gains.
So how can you avoid the tax pain that comes along with some funds, mainly actively managed ones? Here are a few ideas.
Explore the Tax Implications of a Sale
There are two sets of tax costs that you bear as a shareholder of a mutual fund that you hold in a taxable account: You’ll owe tax on any income or capital gains distributions the fund makes over your holding period (regardless of whether you spend or reinvest), and there are taxes on the differential between your purchase price and your sale price. The good news is that those two sets of costs inform one another; if a fund has been making a lot of distributions, that enables you to increase your cost basis (assuming you’ve reinvested the distributions). Thus, when you go to sell your shares, the fact that your cost basis is higher effectively reduces the taxes you owe when you actually sell. In other words, you’ve effectively prepaid a good share of the tax bill you owe on your eventual sale.
You can find your average cost basis (the average price that you personally paid for your shares) on your shareholder statement or in your personalized data on the fund company’s website; compare that with the fund’s current net asset value for a quickie view of the taxes you’ll owe on the sale. Alternatively, if you’re using the specific share identification method for tracking your cost basis and you’ve made multiple purchases of a fund (for example, you’ve dollar-cost averaged into your position), you may be able to identify higher cost-basis lots of the fund to sell without owing much in capital gains taxes. Just be aware that the appreciation on any positions or lots that you’ve held for less than 12 months will be subject to ordinary income tax, rather than the more favorable long-term capital gains tax.
It’s also worth noting that some investors are in the 0% tax bracket for long-term capital gains, which provides an opportunity for tax-free repositioning (provided the sale of tax-inefficient funds doesn’t push you out of the 0% bracket for long-term capital gains). If that describes your situation, you may wonder why bother making any changes in the first place if you’re not going to owe any taxes on the distribution, either. The key reason is that the tax regime--or your situation--could change; if they do and you find yourself on the hook for capital gains taxes eventually, you’ll be glad that you repositioned your taxable portfolio with an eye toward reducing the drag of taxes in the future.
If you’re not comfortable with tax matters (and even if you are), check with a financial or tax advisor before executing the sale. The advisor may also help you identify lower-tax years that are more advantageous for selling than higher-tax ones.
Uncheck That Box
If the tax costs associated with a full-on tax-efficient makeover are greater than you would like, a “lite” way to reposition away from capital gains tax bombs is to not reinvest your capital gains distributions back into the fund. Yes, you’re receiving a step-up in your cost basis when you reinvest your capital gains, but if you’d rather extricate yourself from the tax-inefficient fund than add more to it, unchecking the “reinvest capital gains distributions” box is one way to do that.
For example, let’s say a large-cap growth fund that you own has indicated that it’s about to make a 20% capital gains distribution. (Funds typically begin providing estimates of anticipated distributions starting in late October or early November.) By taking the distribution and shifting it into a more tax-efficient investment rather than reinvesting it, you’ve effectively reduced your tax-inefficient fund by 20%. And the tax costs are a wash, in that you owe taxes on your distributions regardless of whether you reinvest them or steer them somewhere else. (Not reinvesting dividends is another way to reduce your position in a fund, albeit more gradually than described above.) Not reinvesting capital gains distributions is also a way to rebalance. For example, perhaps you've decided that you need to lighten up on stocks overall. If that's the case, you could steer the distribution away from stocks; just remember that bonds and cash are generally less tax-efficient than stocks in that the income on taxable bonds is taxed at your ordinary income tax rate.
Mind Your Asset Location
Last but not least, it’s worth bearing tax efficiency in mind as you position your taxable accounts going forward. Morningstar research clearly demonstrates that exchange-traded funds are a bit more tax-efficient than traditional index funds and that both types of vehicles are significantly more tax-efficient than actively managed options. (Vanguard’s index funds have managed to be nearly as tax-efficient as its ETFs tracking the same indexes because the ETFs are structured as a share class of the traditional index funds.) That means that as you buy and reposition your taxable portfolio, favor ETFs and/or index funds on the equity side; tax-managed funds like Vanguard Tax-Managed Capital Appreciation (VTCLX) can also be a good bet. Individual stocks can work well in this context, too, in that you escape the forced capital gains distributions that come along with funds; your capital gains taxes will be based solely on your own sale. To the extent that you own active equity funds, hold them inside your tax-sheltered accounts.
On the bond side, capital gains taxes tend to be less meaningful, simply because the largest share of your return as a bond investor is income, which is taxed at your ordinary income tax rate. Nonetheless, it’s worth giving due consideration to tax efficiency here, too. To the extent that it’s practical, house bonds within your tax-sheltered accounts to limit the drag of taxes from year to year. To the extent that you own bonds within your taxable accounts--for liquidity purposes or short- or intermediate-term savings--investigate whether municipal bonds might not be the best bet. At the moment, taxable bonds and bond funds generally have a yield advantage over municipal bonds and bond funds of comparable maturities and credit qualities, even accounting for the munis' tax advantages. In a more normal environment, however, investors in higher tax brackets will often benefit from favoring munis over taxable bonds once tax effects are taken into account.
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Christine Benz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.