The year is winding down. That means mutual funds are preparing for capital gains distributions to their investors — and taxes are likely to follow. Around this time of year, mutual funds provide investors with estimates of the gains they can expect to receive at the end of the year. With the S & P 500 up about 24% for 2021 and the major averages notching multiple record highs, this appreciation can be substantial. Although this isn't a problem for investors who keep these funds in tax-deferred accounts, these capital gains bring a tax hit if investors keep the funds in taxable brokerage accounts. These distributions are subject to long-term capital gains treatment : a rate of 0%, 15% or 20%, depending on your income. Keep a look out for a Form 1099 from your brokerage with a breakdown of these distributions — you'll need it to prepare your taxes in the spring. "If you own a fund that's spinning off these distributions, it's good that you made money – but that's the end of the good news portion," Morningstar's director of global exchange-traded fund research, Ben Johnson, said. Morningstar recently compiled a list of funds estimating sizable capital gains distributions. See below for a few notable names. American Century Equity Growth , for instance, estimates a distribution equal to 23% of its net asset value as of Oct. 1. Meanwhile, the AMG Frontier Small Cap Growth Fund sees a distribution that could range from 30% to 36.6% of its net asset value as of Sept. 30. Key drivers behind distributions There are a couple of drivers at work when it comes to mutual funds distributing capital gains. For instance, actively managed funds will likely incur capital gains through turnover in the portfolio. When the fund sells holdings that have appreciated — and it doesn't have sufficient losses in the portfolio to offset the gains — then they must be distributed to investors. Redemptions, which occur when investors exit a fund, can also hit investors who choose to stay put. That's because fund managers need to sell holdings to cash out departing shareholders. Investors are on the hook for distributed capital gains, regardless of whether they reinvest them. They'll face taxes even if they remain in the fund. "Inevitably, the people sitting tight are footing the bill, not for their behavior but because fellow investors in the fund have left the building," Johnson said. Investors receiving capital gains may be tempted to sell out of the mutual fund altogether, but this could backfire and result in an even bigger tax on any realized gains from cashing out. Taxes shouldn't be the sole driver behind selecting investments, but they should be a factor. "One thing that's important to point out is that this is why the direction has been moving toward ETFs where appropriate," Johnson said. "ETFs' tax efficiency isn't any real secret, but it's been the main point of appeal for taxable investors for a long time." Three steps to mitigate the bite Proactive investors have some time to head off the tax hit. Here are a few steps to weigh with your financial advisor and accountant. Search your portfolio for losses to offset incoming capital gains. Underperforming stocks in your portfolio could be plum candidates for selling. Investors can then apply these realized losses toward gains elsewhere in their portfolio, softening the tax hit. This is known as tax-loss harvesting. Know your asset location. Funds that spin out capital gains belong in tax-deferred or tax-free accounts, not in your taxable brokerage account. "I don't understand why you would keep mutual funds in taxable accounts when you can't manage the gains that are distributed at the end of the year," said Dan Herron, founder of Elemental Wealth Advisors in San Luis Obispo, California. "You cost clients more tax dollars that they shouldn't be paying." Do your due diligence. Mutual fund providers post notices of their upcoming capital gains distributions, along with the record date – shareholders on that date are eligible for distributions – and the date when the gains are payable. If you're thinking of investing in a fund, consider making your investment after the gains have been distributed. "Don't make new investments in the fund today – you'll get the same distribution as someone who's been in the fund all year," Tim Steffen, director of tax planning at Baird, said.
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The year is winding down. That means mutual funds are preparing for capital gains distributions to their investors — and taxes are likely to follow.