In a year where most asset classes have seen significant losses, it is hard to comprehend a mutual fund paying out a capital gain at the end of this year. With clients holding mutual funds in a taxable account, this can be especially bothersome as this can generate a taxable event for the shareholder in a year where many funds are down year-to-date. In today’s article, we will dive into how a mutual fund is structured, why these distributions have been paid out this year, and what this means for your account.
A mutual fund is an investment vehicle constructed by an investment company where a portfolio manager, along with their team of analysts and traders, buy and sell underlying securities with a particular objective in mind. Objectives may include strategies such as market cap-specific (large, mid, or small cap companies), fixed income objectives (tax-free municipal strategies, high yield, or investment grade), themes (sector-specific, value, or growth) or even a mix of all at different weightings.
With each specific fund and objective, underlying securities are traded by managers, creating capital gains and losses inside the fund. By law, the fund must pay out 90% of dividends (from the underlying stocks) and realized gains to shareholders annually. Given the volatility we have seen this year, portfolio managers may have traded excessively to keep up with this year’s dynamic market and to meet outflows from their funds as investors liquidate and allocate to cash. In a situation where fund outflows have surpassed inflows (like we have seen in many funds this year), portfolio managers can be forced to sell securities to meet those outflows, thereby creating capital gains and losses.
If there is a net gain from all the securities sold that year to make up redemption requests, these gains will have to flow to the shareholders. Mutual funds will then post a capital gain distribution at the end of the year to comply to regulations and make up for the trading and shifts in the portfolio. In turn, this can create a taxable event for the shareholder regardless if they hold the fund at a gain or loss.
The bad news? During years like 2022, investors can potentially pay capital gain tax on mutual fund positions they hold in taxable accounts. The good news? With proper financial planning and tax planning, these capital gain distributions can be avoided or mitigated. If you haven’t planned for potential capital gain distributions in your taxable accounts, please reach out to our team for a no-cost portfolio consultation.
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Steward Partners Investment Solutions, LLC (“Steward Partners”), its affiliates and Steward Partners Wealth Managers do not provide tax or legal advice. You should consult with your tax advisor for matters involving taxation and tax planning and their attorney for matters involving trust and estate planning and other legal matters.
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