Stock Portfolio Down, Taxes Up - How Does that Happen?

Oct 12, 2015

As we write this, the stock market seems to be on course for its first down year since 2008. While not fun, drops in the stock market are natural and should be expected from time to time. To make matters worse, though, mutual fund investors could end the year with a smaller portfolio, but a larger tax bill.

Taxes and Mutual Funds

Mutual funds themselves generally do not pay taxes.  Rather, it is the shareholders of mutual funds who are on the hook to Uncle Sam.  When holding a mutual fund in a taxable account, investors incur tax liabilities either by selling mutual fund shares at a gain or by receiving distributions from the mutual fund. These distributions are composed of dividends and/or capital gains.  

For dividends, if a mutual fund owns stocks that pay dividends, the mutual fund will collect the dividends and periodically distribute them to its shareholders.  Dividend distributions are usually relatively small as a percent of a fund’s value.  The mechanism for capital gains is similar.  As a mutual fund sells stocks or other securities, it realizes capital gains or losses on the sales.  The mutual fund tracks its gains and losses each year.  If it has a net gain at year-end, those gains must be distributed to shareholders.  These distributions, especially after several good years of stock market returns, can be substantial.  In recent years, distributions of 10%, 15%, and even north of 20% of net asset value (NAV) have occurred.

The Impact of Distributions

While distributions generate a tax bill for shareholders, they also lower the value of a mutual fund.  If a fund with a NAV of $10 per share issues a capital gain distribution of $1 per share, the value of the mutual fund immediately drops to $9 per share.  Shareholders are no better or worse off, but their tax situation has changed.  

In the above example, assume that you bought one share of the mutual fund at $10.  After the distribution, you hold one share worth $9, plus you have $1 in cash.  On a net basis, your total value is still $10, but it is now held in two separate places.  Regardless of whether the distribution is taken in cash or reinvested in the mutual fund, that $1 is taxable.  In effect, the capital gain distribution has “pulled forward” some tax liability.  

Less Value, But Still Pay Tax

In a case like this year, where markets could finish the year in negative territory, investors may be looking at a “double whammy.”  Consider a mutual fund purchased at $12 a share that is currently worth $9 a share.  The investor has a $3 per share unrealized loss.  If the fund declares a dividend or capital gain distribution before year end, the investor’s unrealized loss will increase while they receive taxable income or gains.  Your account has gone down in value, yet you still get stuck with a tax bill.  Ouch!

What Can You Do?

If investors hold mutual funds with large unrealized gains, there is often little that can be done about distributions.  Selling could generate a larger tax liability than receiving the distribution.  However, in cases where there are small unrealized gains or even unrealized losses, there are some strategies to consider.  

Most mutual fund companies release information on estimated year-end capital gains distributions beginning in October.  Investors can get an idea of how big these distributions will be as a percent of the value of the mutual fund.  They can then decide if it is better to receive the distribution or if they should sell the mutual fund and realize a smaller gain (or even a loss).  This can be especially important for those taxpayers subject to the Medicare surtax on net investment income, which can bump capital gains tax rates as high as 23.8%.

Summary

A down year for the stock market can be unpleasant, but it is a fact of life.  If possible, don’t let capital gain distributions make it even worse for you.  Take the time to look at your situation and figure out if there is a way to minimize or eliminate your tax liability.

Schedule a Consultation

Prior to implementing any investment strategy referenced in this article, either directly or indirectly, please discuss with your investment advisor to determine its applicability. Any corresponding discussion with a Bedel Financial Consulting, Inc. associate pertaining to this article does not serve as personalized investment advice and should not be considered as such.

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