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

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.  

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.

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