I start having conversations about mutual fund capital gains at this time of the year. Many mutual funds, especially the more aggressive, growth focused mutual funds, will start to announce the capital gains they have realized during the year. As of September 30th, most stock market indexes are positive for the year, some are up double digits. We also saw a spike in volatility toward the end of the third quarter as interest rates hit multi-year highs. Finally, many funds start to reposition their portfolios at this time of year to clean things out and try to take advantage of any market momentum. They call this repositioning “window-dressing”. The result of this year-end flurry of activity is potential capital gains which are taxable to the fund’s shareowners, not the fund. Maybe the value of your mutual fund is up, it may be flat, or it might even be down. Unless you chose to sell a profitable investment holding in your non-retirement account, you wouldn’t expect to get a 1099 showing any capital gains…but think again. Allow me to explain.
What do 2000, 2001, 2002, 2008, 2018 and 2022 all have in common?
Your first thought might be about negative returns in the stock market, and you would be right. However, another commonality amongst those years are capital gain distributions from mutual funds, including index funds!
Whether the stock market has a positive or negative year, capital gains are always a possibility. Mutual fund shareowners have no control over what a mutual fund owns, buys, or sells. The fund management team makes those decisions in their pursuit of the fund’s investment objective. So, in years when the stock market finishes in negative territory, a shareholder may still see their mutual funds distribute taxable gains to shareholders. That means that the value of your mutual fund may have dropped, possibly significantly, but you may still receive a 1099 and may still owe capital gain tax!
You’re probably asking how a drop in the value of an investment can result in owing capital gains tax? It’s all about turnover in the mutual fund(s) you own. Mutual fund turnover is a measure of how often holdings are bought and sold in a fund. In volatile markets, like those mentioned above, turnover may be higher than normal. Remember, you have no control over the buying and selling of the holdings within the mutual funds you own. Additionally, capital gains, or profits, from the sale of these holdings are based on when the fund purchased the holding, not when the investor bought into the fund. So, if you own a mutual fund in a non-retirement account, you may end up paying tax on gains that you did not fully participate in!
So, how are these taxes controllable you may be asking? Remember this…sometimes asset location is as important as asset allocation. Don’t just build a diversified portfolio of mutual funds. Consider the tax efficiency, or inefficiency, of your chosen investments when you decide what to buy in taxable and tax-deferred/free accounts. My advice… There may be better options than buying mutual funds in a non-retirement account. Rather, build a portfolio of more tax efficient investments such as individual stocks and exchange-traded funds (ETFs) instead. By doing this, the investor completely controls taxable transactions and is taxed on their own profits rather than those of a mutual fund. If you don’t feel confident or qualified to build your own portfolio, look to an experienced advisor to help.
Live Well-Retire Better
Live Well-Retire Better™ is a non-traditional financial planning process that was developed based on my philosophy that you don’t have to choose between enjoying the pleasures of life while working and saving for a comfortable retirement. Although nothing is guaranteed, with commitment, discipline, and careful planning, you can enjoy the comforts of life now, AND when you retire.
If you’d like to talk about The Live Well-Retire Better™ method of financial planning, or have questions or concerns, please set up a call. There is never a charge or any obligation for an introductory conversation.
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The views stated in this piece are not necessarily the opinion of Cetera Advisors LLC and should not be construed directly or indirectly as an offer to buy or sell any securities. Due to volatility within the markets, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results.
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Asset allocation, which is driven by complex mathematical models, cannot eliminate the risk of fluctuating prices and uncertain returns.
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