It’s been a banner year for actively managed stock mutual funds, with 21.1% average growth through October, according to Morningstar.
However, year-end payouts may soon put a damper on double-digit returns, triggering tax bills for funds in brokerage accounts.
When a fund manager sells underlying assets at a profit without losses to offset it, they must pass those gains to shareholders along with dividend income.
The payout typically happens once per year, in December, after the fund announces an estimate in late October or early November.
While the gains aren’t a problem in tax-deferred accounts, such as 401(k) plans or individual retirement accounts, investors with mutual funds in brokerage accounts may owe levies on these payouts.
“It always throws a little wrench when we’re doing end-of-year tax planning for clients,” said Andy Pratt, partner and director of investment strategy at The Burney Company in Reston, Virginia, which ranks 38th on CNBC’s 2021 FA 100 list.
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After receiving a mutual fund’s estimate, investors have until the “date of record,” or the last day to be listed for a payout, to make ownership changes.
If there’s been no growth, they may consider selling before the date of record and then rebuying after the payout, said Jeremy Jones, chief investment officer at Richard C. Young & Co., in Wakefield, Rhode Island, No. 5 on the FA 100 list.
However, if investors sell at a loss and re-purchase a “substantially identical” fund within 30 days, they may violate so-called wash sale rules, and the IRS won’t recognize the loss for tax purposes.
Selling appreciated funds is tricky since it also triggers taxable gains, and the profits may be larger than the fund’s estimated payout.
Moreover, offloading assets to avoid a payout may not align with someone’s investing plan.
Future purchases
Investors also need to be mindful about future mutual fund purchases, particularly through the end of the year.
“If you buy the day before the date of record, you will get the tax hit,” said Michael Bisaro, president of StraightLine Group in Troy, Michigan, which ranked 92nd on the FA 100 list. “And you might have owned it for three days.”
After reviewing the estimated payout, investors looking to avoid extra levies may purchase a mutual fund after the date of record or keep the fund in a tax-friendly account.
If you buy the day before the date of record, you will get the tax hit. And you might have owned it for three days.
Michael Bisaro
President of StraightLine Group
Tax-loss harvesting
While advisors typically seek stock market dips to offset gains by selling losing assets through so-called tax-loss harvesting, continued growth has made the strategy more difficult to use.
“The stock market has not given us the opportunity a lot over the last few years,” said Bisaro.
However, if there’s any pullback through the end of the year, advisors may consider selling some assets, depending on clients’ goals, he said.
In the meantime, investors expecting payouts may work with an advisor to try and reduce levies through other year-end tax planning moves.
Be proactive
While it may be difficult for some investors to bypass this year’s tax hit, advisors suggest a proactive approach for the future.
“It’s about being really transparent and knowing what your capital gains situation is all year long,” Pratt said.
For example, many advisors consider tax efficiency when building portfolios, opting for mutual funds with less turnover and fewer distributions. But some taxable gains may still happen.
“We try and make that a part of our communication from the beginning and throughout the time we’re working together to reframe it a bit,” Bisaro said.
