There may be some pain ahead for mutual fund investors in the form of capital gains taxes. While their investments have lost value during this year’s market rout, they still may receive a capital gain distribution from their actively managed fund. “Because of selloff-triggered outflows and the ongoing trend of investors swapping actively managed stock funds for passive exchange-traded funds, many managers have had to realize some of those gains to meet redemptions,” Stephen Welch, a research analyst at Morningstar, recently wrote in a report . As fund managers sell their holdings to cash out departing investors, they incur capital gains, which are distributed to the remaining shareholders. Those distributions are subject to taxes if the fund is held in a taxable account. “That means funds that have suffered steep falls this year could still distribute capital gains to investors,” Welch said. Morningstar looked at preliminary distribution estimates from some of the larger fund families, studying several funds with varying distributions at each firm. The estimated distributions range from as low as 0%- 1% of net asset value in the Royce Global Financial Services Fund to as high as 88% of NAV in the Delaware Sustainable Equity Income Fund . The estimates may still be revised, with payouts coming between late November and the end of the year. Here’s a sampling of what Morningstar found. Of the firms mentioned here, several AllianceBernstein funds are on track for distributions between 6% and 12%, while Ariel’s US strategies funds payouts range between 7% to 11% funds’ net asset value (NAV). Many Fidelity Funds will pay more than 5%, with its SAI Real Estate fund likely to distribute 19%. Several Franklin Templeton funds will make double-digit distributions — some will be as low as 4% and others as high as 15%. Meanwhile, a handful of Janus Henderson funds will distribute 5% to 10% of assets. John Hancock will pay double-digit capital gains distributions on several of its funds. JPMorgan has several funds with high-single digit to low-double digit payouts, as well as one, its US Large Cap Core Plus Fund, expected to distribute 24%. Almost a dozen Nuveen funds will make 5% to 10% capital gains distributions, while twice that number of T. Rowe price funds will pay out between 4% and 21%. Lastly, several TIAA-CREF funds will make distributions between 6% and 12%. CapGainsValet website offers a free search of simplified capital gains estimates for the largest mutual fund firms. Should you stay or should you go? First, recognize which accounts will be affected — only those in taxable accounts will be subject to taxes on distributions, not those in 401(k)s or IRAs. If held in a taxable account, you’ll owe taxes of 0%, 15% or 20% — depending on your income — for assets held for over a year. If they were held less than a year, they will be taxed like regular income . However, investment fundamentals should always be the main driver in your decision of whether to stick with your mutual funds or get out, said Christine Benz, Morningstar’s director of personal finance. That means sticking with it if you believe in the investment. However, if you are on the fence about the holding, see if you can find a passively managed fund with similar exposure, she said. Passively managed funds may have distributions but they tend to be smaller than actively managed funds, Benz pointed out. However, if you decide to sell, first check to see how much the position has appreciated since you purchased it, she said. “You can dodge the impending distribution by selling, but you also may unlock your own tax bill if the position has appreciated since you purchased it,” Benz said. There are different ways to figure out your cost basis, which is what is used to determine your tax liability. The cost basis is essentially the amount you paid for your mutual fund shares, minus the value of any taxable capital gains or dividend distributions that were reinvested in the past. The default option is an average cost basis. If you have purchased shares at multiple intervals, this method averages all the prices of the purchases together. Benz recommends another route — the specific share identification method, which allows you to pick which positions you want to sell. Therefore, you could choose to sell a newer position that has appreciated a lot less than an older one, she explained. The caveat is that you can’t choose this option if you have used the average cost basis in the past. It’s also important to know how long you have held the asset before you sell it so you know if you’ll be paying the steeper short-term capital gains tax or the long-term one, said certified public accountant Philip Mitchell, president at Kroon & Mitchell Asset Management in Grand Rapids, Michigan. Then there is the additional net investment income tax of 3.8% for those married filing jointly with income above $250,000 or those single making $200,000, he said. Another thing to bear in mind is a higher income resulting from the investment sale may mean you are paying more in Medicare part B premiums, which are based on your modified adjusted gross income, said Mitchell, a member of the personal finance planning executive committee for the Association of International Certified Professional Accountants. It could also affect the amount of taxes you pay on any Social Security benefits, he added. “Start to add up the pros and cons,” Mitchell said. “It is not always clear cut.” If you decide to sell after determining your tax liability, be sure to do it before the record date, which is the date you must own the shares in order to receive the distribution, he added. You can also look at your portfolio holistically and see if there is any tax loss harvesting that can be done elsewhere, which offsets any profits made this year with losses. New investments Those thinking about adding new investments to a taxable account may want to consider passively managed funds, like index funds or exchange-traded-funds, Benz said. “Most actively managed funds are not a great fit for a taxable account,” she said. “You lose control of your tax position.”
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