Investors may be surprised by capital gains distributions from their mutual funds this year.
The size of the payout depends on the fund and its investment strategy. A fund that holds stocks for long periods, such as an index fund, will have fewer distributions than actively managed funds that frequently trade.
Mutual fund research firm Morningstar has estimated the average distributions for U.S. stock funds with capital gains by percentage of net asset value from 2011 through November 2016. Distributions are lower so far this year because most payouts take place in December. (See chart below.)
Investors should start by gauging how meaningful the capital gains distributions are to their portfolios.
Distributions are only an issue for investors if they hold mutual funds in a taxable account. (If you keep funds in retirement accounts, such as traditional or Roth IRAs, you need not worry about the distributions because taxes on those gains are deferred until you withdraw money from those accounts.)
Most funds give investors estimates of what their capital gains will be for the year in November. It's not just how the fund performed in one year that causes the distribution. A fund could have held onto its winners from last year and sold them this year, generating a larger capital gain.
"First, determine if the distribution is significant, 5 percent or higher, or insignificant, less than 5 percent," said Sterling Neblett, a certified financial planner and founding partner of Centurion Wealth Management in McLean, Virginia. "If the distribution is significant, we compare the tax consequences of taking the distribution with the tax consequences of selling the fund or sidestepping the distribution."
For example, if you bought a stock fund this year that gained 14 percent and has a long-term capital distribution of 6 percent, you might be better off taking the distribution rather than incurring a 14 percent short-term capital gain, Neblett said. Why? Because short-term capital gains are taxed at a higher rate than long-term ones.
You can avoid capital gains altogether if you have losses to neutralize them in a strategy called tax-loss harvesting.
Here's how it works: You sell investments to generate losses. You use those losses against your capital gains. If your losses are larger than your gains, you can apply up to $3,000 a year in capital losses to reduce your ordinary income. If you still have capital losses, you can carry them forward for use in future years until you use them all.
"You might be able to offset a large distribution, but you need to act before year-end," said Mark Wilson, a CFP, portfolio manager at the Tarbox Group in Newport Beach, California, and founder of CapGainsValet.com, which provides free capital gains distribution estimates for the funds offered by the 250 largest sponsors.
Be aware of the wash-sale rule, which can thwart your tax-loss harvesting strategy.
The Internal Revenue Service prohibits you from claiming a loss on the sale of a security or fund if you buy a "substantially identical" security or fund within 30 days before or after the sale.
"If our analysis suggests that the most tax-efficient strategy is to sidestep or sell the fund to avoid the capital gains, we will typically purchase a similar [exchange-traded fund], different enough to avoid a wash sale, for 31 days before repurchasing the fund," Neblett said. That way a portfolio maintains its asset allocation while harvesting the tax loss.
However, the Trump rally had made it harder for investors to find tax losses. "At this point in the year, there are not many losses to take," said Kerry Mayo, a CFP and certified public accountant at Capital Financial Advisors of New York in Clifton, New York. "There may be some in foreign bonds, but that's about it."
If capital gains distributions were a problem for you this year, you might consider a more tax-efficient portfolio in 2017.
Cynthia Turkington, a CFP and founder of Fair Trust Financial in North Oaks, Minnesota, recommends clients use exchange-traded funds in taxable accounts.
"With traditional mutual funds, you are not in control of year-end capital gains distributions. The mutual fund company determines the distributions based on the amount of turnover, or buying and selling within the fund during the year," Turkington said. "With ETFs, you are taxed on dividends, but not on capital gains until you decide to sell."
Several major robo-advisors provide automatic tax-loss harvesting, including Betterment, Charles Schwab and Wealthfront, for their ETF portfolios.
If you prefer active management to indexing, you can find funds with managers who invest with an eye for tax efficiency.
Check out a fund's distribution details before you add it to taxable accounts at the end of the year, Wilson said. "Do not buy a tax headache."