Three steps to prepare for capital gain season

1. UNDERSTAND

Every year, mutual funds and some ETFs are required to distribute recognized capital gains during the fiscal year. By actively managing a fund or replicating a defined benchmark, actively selling a stock (or bond) for a price higher than paid initially may lead to realized net capital gains.

For taxable investors, these distributions are taxable, even if they’re being reinvested into their investment account. The IRS still wants their cut – even if the investor never took possession of the distribution.

Most mutual fund companies will post their capital gain estimates in October/November, with the actual distribution in December. In early 2024, investors will receive their 1099-DIV (usually part of the Consolidated 1099) with the specifics on the distributions’ amounts and character (Long-Term or Short-Term).

In addition to capital gains, funds may also have taxes from dividends and interest income. This taxable income is separate from capital gains and another cause of tax drag.

2. CONSIDER?

Are capital gain distributions good or bad? Like so many things in investing, it depends! No one wants to pay a tax. That never feels good. But the goal for taxable investors should be to maximize after-tax wealth – not simply working to avoid taxes. One must consider:

• The return of the fund making the distribution. Was the pre-tax return attractive when considering the taxable distribution? It’s possible that even with the distribution, the after-tax return is attractive vs. other investment options. Don’t only consider the current year but the entire holding period the fund has been held.

Example: Assume two funds with $1,000 invested – Fund A and Fund B.

Fund A had a pre-tax return of 10% and a capital gain distribution of 5%. The investor would receive a 1099-DIV with a capital distribution of $50 (5% of $1,000). Assume a long-term capital gain tax rate of 15%, the after-tax return = 9.2%.

Fund B had a pre-tax return of 8% and a capital gain distribution of 0%. The investor might celebrate $0 taxable distributions, but their after-tax return would be 8%.

Which fund would you prefer? Fund A paid a tax but also had a higher after-tax return, i.e., more after-tax dollars. One must ask: What is the goal? Avoiding a tax or investing for higher after-tax wealth?

3. TAKE ACTION

If capital gains are deemed “bad,” here are some possible actions:

• You may be tempted to sell the fund before the distribution. Consider if selling the fund will trigger an equal or higher tax on the liquidation. The math may lead to keeping the fund, paying the tax, and evaluating for another day.

• If you want to sell, do you have a more compelling alternative to transition to? Have you lost faith in the fund with the distribution? If you still have high conviction in the fund, holding on through the distribution may be warranted. Does the investment rationale still hold for the investment? The capital gain distribution may make sense, given the investment environment.

• If you have lost faith in the investment product, you may choose to make the move, sell the fund, and move on. Ensure you understand the tax impact of selling before the distribution vs. after. You may want to sell the fund in the following year to defer that tax into the next year.

Investors should keep their eyes on the larger goal – higher after-tax wealth. A tax-smart investment approach will incorporate the tax-efficiency and after-tax returns of active mutual funds, index funds, and ETFs. It should not be an either/or for these options but a thoughtful consideration of all available options. The upcoming capital gain season is a great chance to review the after-tax returns for funds and portfolios. Success should be defined by after-tax returns, not by only minimizing taxes.