Mutual funds have long provided a simple way for Americans to diversify their assets and invest for the future. While there are historical examples of pooled investments throughout history, modern mutual funds can trace their roots back to 1924 when the oldest still existing mutual fund MFS Massachusetts Investors Trust (MITTX) was established.
The primary attraction of mutual funds over the years has been the ease of diversification and affordable access to professional managers which has helped the US mutual fund industry grow to control over $20 trillion in assets.
While the diversification and access to professional management helped mutual funds amass a significant share of America’s investment portfolios, they are no longer the only options to achieve these benefits (i.e., exchange traded funds, direct indexing, etc.). Nevertheless, with the industry built around mutual funds and the profit motives that go with them, mutual funds have continued to be the dominant investment vehicle for many Americans.
While most individuals are familiar with mutual funds, very few are familiar with how their ownership of mutual funds impacts their taxes. Often the tax results can create an unpleasant surprise for the unsuspecting investor.
Basics of Mutual Fund Taxes:
Before beginning a discussion on the tax impacts of owning shares of a mutual fund, it is important to differentiate the treatment of shares held in a tax advantaged retirement account (IRA, Roth, 401k, etc.) versus a taxable brokerage account. The tax discussion that follows is directed toward shares in a taxable brokerage account since shares in a tax advantaged retirement account benefit from tax-deferred or tax-free treatment depending on the type of account.
To understand how taxes on mutual fund ownership impact individual investors, it is important to understand that owning shares of mutual funds can trigger taxable events for investors at two levels.
The first level is the individual investor level. Individuals who purchase mutual fund shares realize gains and losses from the change in the share price during their ownership similar to owning individual stocks. Those gains/losses are taxable at the time they sell their shares.
However, mutual funds have an additional layer of complexity that can result in taxable events that are entirely out of the investor’s control. Mutual funds are required to pay out the net capital gains realized within the fund due to ongoing management of the underlying portfolio. Those payouts, called capital gain distributions, are taxable income to the investors. This adds an added layer of complexity because an investor who did not sell any of their shares can still be hit with a large capital gain distribution.
The following graphic demonstrates the two levels of activity that can result in taxable events for mutual fund investors.
What makes matters worse is the tax rules don’t provide an exception for investors who recently purchased their shares. For example, an individual who purchased shares of a mutual fund a week before it passes out its annual capital gain distribution will be liable for tax on the full distribution despite the fact that they did not participate in the increase in share price that led to the capital gain distribution in the first place.
This disparity between owing taxes based on the activity of the underlying fund versus the investor’s own activity of buying and selling shares of the mutual fund itself can result in significant tax surprises and lost tax efficiency for individuals.
Key Takeaway:
Both the activity of the individual investor who owns the mutual fund and the underlying activity in the mutual fund portfolio can result in taxable events to investors.
2022 Perfect Storm:
Nearly every asset class struggled in 2022 with most benchmarks showing significant losses. The S&P 500 ended the year with a -18.11% total return which was further surpassed by the difficulties of the technology industry which led the NASDAQ to an even larger decline of -32.54%.
The challenges of 2022 came right on the heals of a very strong market performance in 2021 when the S&P 500 was up 28.71%.
When it comes to mutual funds, the difficult year in 2022 that followed on the heels of the exceptional performance in 2021 created the perfect storm for a significant tax surprise for investors.
The significant run up in values during 2021 created large unrealized capital gains within many mutual funds. As is typically the case, many investors flocked to the funds with the best performance just in time for the next market downturn.
As the downturn in 2022 took hold, many investors wanted to exit their mutual fund positions which forced mutual funds to sell underlying positions to fund the redemption requests. Given the 2021 run up in prices, those sales generated capital gains despite the market being down in 2022 (i.e., sale prices were still above the initial purchase price despite the market being down for the year). As a result, many investors received capital gain distributions in 2022 despite the fact that the value of their shares declined significantly.
Russell Investments estimated in December that the total 2022 capital gain distributions to be paid out on US equity funds would be 6.6% of net asset value despite US total returns being down significantly. This is similar to past examples such as 2008 and 2018 when the market was down, but investors received substantial capital gain distributions of 8% and 11%. Paying taxes on significant capital gain distributions when the market is down can be a substantial drag on long-term performance.
Key Takeaway:
The market movement between 2021 and 2022 created the perfect storm to highlight the potential tax inefficiencies of mutual funds.
The Shift to Passive Investing:
Another phenomenon contributing to capital gain distributions is the massive shift that is currently underway in the asset management industry – the shift from active to passive management. In the early 2000s, passive investing (i.e. index investing) was just beginning. However, over the past two decades, passive investing has grown to challenge active investing as the most popular investing strategy in many asset classes.
As individuals shift from active to passive investing strategies, they are transitioning out of actively managed mutual funds. This transition forces the actively managed funds to sell positions to fulfill the redemption requests which creates capital gains that are passed on to the remaining shareholders in the active funds.
Reasons To Avoid Capital Gain Distributions:
While it is clear that paying taxes at any point is painful, there are some very important reasons that avoiding ongoing capital gain distributions is particularly important.
First, paying taxes at a time when your portfolio is at a low point is especially costly. When capital gain distributions occur after an investor’s portfolio has declined, the long-term impact of the taxes paid is larger. Once the taxes are paid, there are less dollars to rebound when the market eventually recovers. The overall effect is that the taxes take a bigger bite out of the investor’s portfolio.
Second, realizing capital gains on an annual basis rather than deferring them during your entire holding period is not tax efficient. For example, capital gain tax rates can range as high as 23.8% federally plus additional state tax. If the average capital gain distribution is 6.5% and we assume a combined federal and state capital gain rate of 25%, that is 1.63% in lost return annually due to taxes on capital gain distributions.
Over a 30-year period, this results in substantially less accumulation of wealth. For example, assuming two portfolios that both begin at $500,000, if one grows at 10% and the other grows at 8.37%, the difference in total net worth accumulation at the end of 30 years is $3.15M dollars as shown below.
Third, capital gain distributions disrupt the ability of investors to defer capital gains for life. For individuals who expect to have more assets than they will spend during their lifetime, deferring the capital gains for life and then passing those assets to their heirs results in a stepped-up tax basis in taxable brokerage accounts equal to the fair market value of the shares on the date of the original owner’s death.
Heirs who receive a stepped-up basis can sell the shares and fully avoid any tax on the appreciation that occurred during the lifetime of the original owner. Conversely, ongoing capital gain distributions force the original owner to pay taxes during their lifetime and significantly reduces the value of receiving a stepped-up basis.
Finally, capital gain distributions make tax planning more difficult. Individuals who engage in annual tax planning create income estimates to determine the tax impacts of various planning opportunities such as completing Roth conversions, avoiding the net investment income tax, managing their ordinary and capital gain tax brackets, and so on.
When these individuals own substantial mutual fund positions in taxable brokerage accounts, the amount of capital gain distributions they will receive is often an unknown until late in the year. This can substantially impact the accuracy of their tax estimates and therefore, has a significant impact on their ability to make accurate tax planning decisions.
!!!NOTE!!! If you are interested in knowing whether you are being taxed on significant capital gain distributions, check Line 13 of Schedule D on your tax return which reports all of your taxable capital gain distributions for the year.
Key Takeaway:
Capital gain distributions reduce the tax efficiency of your portfolio, decrease the potential for long-term growth, and make tax planning more difficult.
How to Avoid Capital Gain Distributions:
For individuals with taxable brokerage accounts, creating a strategy to avoid the tax inefficiency and tax planning challenges caused by capital gain distributions is important. The first step in the process is for investors to avoid making their current situation worse.
Don’t Make the Problem Worse: Individuals who already hold highly appreciated mutual fund positions that are paying out capital gain distributions often cannot sell the highly appreciated shares without significant tax consequences. In that case, the tax consequences of selling might outweigh the cost of continued capital gain distributions.
However, it is important that the investor doesn’t perpetuate the problem by purchasing more of the same shares through dividend and capital gain reinvestment. Instead, it is usually best for the investor to take the dividends and capital gains as cash and redirect those funds to other more tax efficient investments.
It is also important for individuals who have highly appreciated mutual fund positions to review each individual tax lot to see if there are tax lots that have a higher cost basis and can be sold without a significant tax obligation. If so, it is usually best to sell those tax lots and use the cash to invest more tax efficiently.
More Tax Efficient Investment Options: Option 1 – Purchase Funds With Low Embedded Gains and Turnover Rates: If an individual prefers to own mutual funds, the first option to reduce the capital gain distributions received is to own funds that are not expected to pay large capital gain distributions. There are two components to consider in this regard, embedded capital gains and fund turnover rate.
Embedded Capital Gains: An investor that is buying into a mutual fund is typically purchasing a share of a fund that has already been managed for a period of time. If the mutual fund’s holdings have appreciated, a portion of that fund represents embedded capital gains. If the fund sells those appreciated positions, the investor will receive a capital gain distribution and pay tax on it.
Embedded capital gains are reported for each mutual fund and can be found on Morningstar.com. Investors can look to see whether the funds they are intending to purchase already have significant embedded gains as an indicator of future capital gain distributions they will likely receive.
Turnover Rate: Turnover rate represents the portion of the fund’s holdings that are bought and sold in a given year. Actively managed funds usually have much higher turnover rates than passively managed funds. For example, an actively managed fund like the Vanguard Equity Income Fund (VEIPX) has a turnover rate of 40% whereas a passively managed fund like the Vanguard 500 Index Fund (VFINX) has a turnover rate of 2% (data as of March 2022).
A fund with large embedded gains and a high turnover rate is likely to realize significantly more capital gains than a fund with low embedded gains and a low turnover rate. Investors can reduce the amount of capital gain distributions they expect to receive by focusing on funds with low turnover and low embedded gains.
Option 2 – Purchase Individual Securities: This option is not for everyone, but for those individuals who are interested in doing their own research and putting in the time, purchasing a diversified portfolio of individual stocks rather than mutual funds removes the possibility of capital gain distributions entirely because the investor gets to make all the decisions to buy and sell the individual positions themself.
This removes the challenges that arise in a mutual fund where the individual investor is bound to the decisions of a portfolio manager who does not understand the specific needs and interests of individual fund investors.
Option 3 – Use Exchange Traded Funds: Using exchange traded funds (ETFs) is often the best option for individuals. ETFs are similar to mutual funds in the sense that they hold a diversified portfolio of underlying securities and are managed by experienced portfolio managers. In fact, there are many ETFs and mutual funds designed to mirror each other.
ETFs are subject to the same rules regarding capital gain distributions as mutual funds. However, the structure of ETFs significantly reduces the likelihood and amount of capital gain distributions that are paid out.
With ETFs, instead of share purchases and redemptions being settled between the fund and the investor directly, shares are traded on exchanges. As a result, individual investors buy and sell shares from other investors which has no impact on the underlying ETF portfolio. Accordingly, ETFs do not have to sell positions to fund redemption requests of their shareholders. This reduces the opportunities for capital gains to be realized by the ETF itself.
Additionally, when ETFs create and redeem shares, they do so through large financial institutions called authorized participants. These transactions with authorized participants are often settled using shares of the underlying portfolio holdings (i.e. in-kind) rather than in cash.
When these transactions are settled using shares, there is no taxable event. This allows ETFs to remove the most highly appreciated positions from their portfolio over time through in-kind transactions with authorized participants without triggering a taxable event for investors.
According to iShares by Blackrock, ETFs account for 24% of US managed fund assets but are responsible for less than 1% of total capital gain distributions. Overall, the structural benefits of ETFs significantly reduce the likelihood and amount of capital gain distributions paid out to investors.
Option 4: For individuals who are interested in taking tax efficiency a step further, direct indexing is a strategy worth considering. With direct indexing, rather than purchasing a mutual fund or ETF that tracks an index, the individual directly holds the underlying assets in the correct proportion to match the index. Typically, direct indexing is implemented through a managed account with an advisor or a large custodian.
Direct indexing gives the investor the ultimate flexibility. Overall, the portfolio’s performance will still track the index, but the individual investor can more effectively implement tax efficient strategies by having direct access to the underlying positions with the most extreme performance.
Access to the positions with the most extreme performance maximizes the effectiveness of tax loss harvesting by creating the ability to sell the positions with the biggest losses and increases the effectiveness of charitable giving by allowing the individual to gift the positions with the most appreciation.
In the end, investors have multiple options that will help them increase the tax efficiency of their portfolios. Those who take the time to implement a tax efficient strategy can avoid the diminished portfolio growth that often occurs due to taxes on mutual fund capital gain distributions.
Key Takeaway:
Investing in mutual funds with low embedded gains and turnover rates, purchasing individual securities, investing in ETF’s, and direct indexing are potential strategies to reduce and avoid capital gain distributions.
Conclusion:
While the US mutual fund industry has been the predominant player in helping individual investors craft diversified, professionally managed portfolios, the ongoing capital gain distributions can result in tax consequences that surprise investors and significantly reduce the long-term value creation of their portfolios.
While it is possible to reduce the amount of capital gain distributions an investor receives by focusing on mutual funds that have low embedded capital gains and low turnover rates, often the best solution is to focus on other investment strategies in the first place such as exchange traded funds or direct indexing. These strategies provide many of the same benefits as mutual funds but have additional flexibility to increase the tax efficiency of the overall portfolio.
Investors who structure their investments to avoid capital gain distributions will have a more tax efficient portfolio that can lead to additional wealth creation over time. If they do not need to spend all their wealth during their lifetime, they may even be able to achieve a stepped-up basis in their portfolio which allows their heirs to avoid paying taxes on all the appreciation realized during the original investor’s lifetime – substantially increasing the original investor’s ability to pass wealth to the next generation.
If you are interested in having one of our Family CFOs review your tax return to see if you are paying taxes on significant capital gain distributions or if you are interested in meeting with one of our Family CFOs to learn more about how to create a tax efficient investment portfolio, we would love to connect to see if what we do is right for you.
