By Joe Riley, CFA, Advisor Directed Portfolio Analyst
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The strong stock and bond markets of the past decade, combined with the quickness of the 2022 pull back in the values of both, make it especially important to monitor the expected year-end capital gain distributions for your mutual funds this year. The long run of mostly positive returns since the Great Financial Crisis built up a large base of unrealized capital gains within many mutual funds’ portfolios, only to have those gains be recognized this year due to large shareholder outflows in response to the 2022 bear market. To understand why, a little background on how mutual funds operate may be in helpful.
Mutual funds are considered by the IRS to be pass-through securities, meaning they don’t pay taxes themselves, rather they pass through any gains to their fundholders who are then required to pay whatever taxes are due. Over time, this can mean that your mutual fund will rise in value, then towards the end of every year it will make a distribution to the fundholders who then pay taxes on it. If a fund holder is reinvesting their dividends and capital gains, this will result in the fund holder’s cost basis gradually rising over time although typically lagging slightly behind the rise in the mutual fund’s share price.
Although not common, occasionally the financial markets can pull back so steeply and suddenly that a mutual fund’s share price can dip below that rising cost basis (creating what is termed an Unrealized Capital Loss), even for funds that have had good returns. Additionally, those very same sudden market pullbacks can also jolt some mutual funds to the extent that they must disregard their normal portfolio position exit strategies in order to return funds to holders who have been shaken out of the market. When this occurs, those funds may be required to make larger than normal capital gain distributions to their holders all while those holders are simultaneously carrying a capital loss.
Being forced to pay taxes on a fund that, on paper at least, you’re carrying a loss on is not a pleasant experience. Under the right circumstances, however, there is something that can be done about it. If you are currently invested in a mutual fund in a taxable account (i.e., not an IRA or 401k) and are able to switch funds without incurring transaction costs, you may be able to reduce your tax bill for the upcoming year.
First, you’ll need to know if your fund has an unrealized gain or unrealized loss – information that is usually available on your financial statements or your institution’s website. If it’s an unrealized loss, you can go to the fund company’s website and find their expected capital gains for the fund in 2022. Any estimated distributions approaching 10% could be considered unusually high and may be worth trying to avoid while recognizing the unrealized loss via “tax loss selling.”
Tax loss selling is a legitimate but complicated financial strategy that is best done with the advice of a licensed financial advisor or tax professional to avoid the possible pitfalls of doing it wrong. A short list of the things that need to be done correctly are: selling before the fund’s record date, properly reinvesting the sale proceeds (you want to be invested in a similar investment, but it can’t be too similar), and knowing when and if you should move back to the original fund. Recognizing the loss in combination with sidestepping some of this year’s larger gains could result in a meaningful improvement on your 2022 tax bill, but the process has to be done correctly in order for the IRS to allow the sale to count as a deductible capital loss.
Mutual Funds are sold by prospectus only. Please consider the investment objectives, risk, charges and expenses carefully before investing. The prospectus, which contains this and other information, can be obtained by contacting your financial consultant. Read it carefully before investing.
Benjamin F. Edwards does not provide legal or tax advice, therefore it is also important to consult with your legal and tax professionals for additional guidance tailored to your specific situation.