In talking with a client and their tax advisor this week, there was some confusion over why mutual funds make distributions (typically in December) that result in unexpected tax consequences. It’s a great question and one you should keep in mind for your portfolio, especially in 2022. Let’s dive in.
What is a mutual fund distribution?
Mutual funds are required to distribute any dividends and net realized capital gains earned on their holdings over the past 12 months.
These distributions, whether taken in cash or reinvested into the fund, are taxable to the holder of the mutual fund – provided they are held in a taxable account. (Mutual fund holdings in a tax-advantaged account like and IRA or 401k won’t trigger any tax – until cash is withdrawn from those accounts).
How does a mutual fund generate dividends or capital gains?
Remember that a mutual fund is an investment vehicle holding underlying securities, such as bonds and stocks. These underlying holdings generate income (dividends and interest) just as stand-alone bonds and stock do. Further, as the mutual fund manager buys and sells positions per their strategy, capital gains are generated (ie: difference between purchase price and sale price)
What does this do to the price of my mutual fund?
Mutual funds are valued at the end of each trading value at their net asset value, or NAV. On the date of the distribution, the NAV will be reduced by the amount of the distribution. This does not represent a loss in value to the holder of the mutual fund as that distribution is either paid in cash or reinvested (that is a choice the investor makes). If the distribution is reinvested, it is added to the cost basis of the fund holding, thereby lowering any gain upon ultimate sale of the fund.
Why should I care about this?
If you have mutual funds in a taxable account, these distributions will flow thru to your tax return and be netted against any other capital gains and losses you have generated during the year to determine your total capital gain or loss. Their impact may be minimal or fully offset by other losses you may have (current or prior year carryforwards) – but their impact may also be meaningful to you. It’s worth looking at your mutual fund holdings and doing some calculations before the distributions are paid to decide if you want to incur the distribution.
Do the distributions vary by year?
Yes. They are based upon the underlying activity in the fund. Typically, they increase in volatile years as fund managers tend to make more trades. 2022 was such a year so there is a chance they may be more meaningful this year. However, that generalization is hard to make with any certainty as every fund is different.
Is it possible for a fund in an unrealized loss position to distribute a gain?
Yes. And this is actually pretty likely in 2022. Given the sharp decline in markets this year, many holdings are likely to be in a loss position (ie: current price below what you paid for them). However, with the ongoing trading and management within a mutual fund, there could have been a net realized gain within the fund – even during this down year. That gain will be distributed to you – even if the fund holding itself remains in an unrealized loss position in your account.
How can I calculate my possible exposure?
Mutual fund companies publish estimates and many have already done so. Using that data and detail on your holding (such as units held), you can calculate the expected gain or loss. Combine that result with any other known capital gains or losses from your other accounts or prior years – and well as your overall tax picture (such as income and deductions) and determine if the impact of the distribution is acceptable.
What can I do if that distribution will be overly detrimental?
If you determine that the capital gain will be detrimental to your 2022 taxes (as an example, perhaps it is a short term gain that will push you into a higher income bracket and increase your medicare preimums in the future), you can always sell the fund prior to its distribution. However, be sure to examine the unrealized gain or loss position of the mutual fund in your account as well as a sale of the fund will trigger that entire gain or loss. In addition, you could take other actions tax-wise to help mute the impact. Everyone’s situation will be different.
This sounds complicated. Where can I get help?
As is the case with most investment matters – and tax matters – this is rather complicated and nuanced. You’re forecasting taxes and considering several inputs, as well as keeping in mind your investment strategy and allocation. That’s not to mention you also have to take great care in reinvesting the proceeds to avoid wash sale rules. As is always our advice, we strongly suggest you work with a financial and tax advisor on your specific situation. Just take action soon as many distributions are set to be paid in November and early December.
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