There’s a season for everything: In the spring, you may clean your home from top to bottom. In the autumn, there’s pumpkin-spice everything to celebrate the harvest. As the year draws to a close, there’s also capital gains distribution season, which could impact your finances for yet another time of year: tax season.
If you’ve sold investments, you may already be aware of your capital gains (or losses) for the year. But did you know even if you continue to own a mutual fund, you also could receive a payment from the fund in the form of capital gains distributions?
Here’s why: Funds are legally required to pay you a share of any profits made from portfolio managers selling underlying securities throughout the year. This means you could receive distributions even if the market is down for the year or if your fund’s performance is negative.
If your investments are in qualified, or tax-deferred, accounts such as a 401(k), 403(b), or IRA, these distributions won’t be a tax concern unless you make a withdrawal from those accounts instead of allowing the distributions to be reinvested. In non-qualified accounts, however, you could owe taxes on capital gains distributions even if you choose to reinvest the distributions rather than take them as income.
A Time to Plant, a Time to Reap
Mutual-fund companies disclose estimates for capital gains distributions well in advance of paying them. This gives you time to prepare, if needed. The good news is that there are strategies to offset or defer some of the burden of taxes that accompany capital gains distributions, but you’ll need to plan ahead.
First, if a fund is expected to have a large distribution, consider whether or not it’s time to get out of Dodge. If you sell the fund before the distribution is paid out, you won’t receive a capital gains distribution for the fund, and thus avoid owing any taxes on it (see Example 1). However, if you sell the fund at a profit, this would be considered a capital gain that’s taxable, so it’s important to evaluate which option would have the least impact on your taxes for the year.
Example 1: Avoid Receiving the Capital Gains Distribution
ABC Large-Cap Growth Fund is estimating a large capital gains distribution, and you’re open to redeeming your shares. The distribution will be paid out on December 3 to shareholders of record as of December 2 (the record date).
Redeem ABC Large-Cap Growth Fund by December 1, the ex-dividend date. You won’t receive the distribution, but you may owe taxes on the sale if you earned a profit.
Second, in a strategy known as “tax-loss harvesting,” you can reap the benefits of unimpressive performance. You can intentionally sell investments at a loss, or “harvest” losses, which you can then use to offset capital gains distributions from a fund. You’ll want to plan carefully to keep your asset allocation on track, however, because reinvesting in a substantially identical fund right away can violate the “wash sale” rule.
Example 2: Use Tax-Loss Harvesting to Offset Capital Gains Distributions
You expect to receive a $1,000 long-term capital gains distribution from the ABC Large Cap Value Fund but wish to continue owning it.
You also own the ABC Small-Cap Growth Fund, which has an unrealized long-term capital loss of $1,000.
Redeem ABC Small-Cap Growth Fund and realize the $1,000 capital loss.
Receive the $1,000 capital gains distribution from ABC Large Cap Value Fund.
Use the $1,000 realized capital loss to offset the $1,000 capital gains distribution.
Result: No tax liability
Note: You must now wait for 30 days before buying a fund or security that’s substantially similar to the ABC Small-Cap Growth Fund, otherwise the loss will have to be deferred under the wash-sale rule.
Timing Is Everything
Capital gains distributions are considered either short or long term (see “Talk Like Uncle Sam” for more details). As a mutual-fund investor, this is defined by how long the asset was owned in the fund, not how long you’ve owned your fund shares. You could receive either or both types of distributions from funds you own.
Long-term gains distributions from mutual funds can be offset with capital losses. Short-term capital gains distributions from mutual funds, however, are considered “ordinary dividends” and treated as an income distribution for tax purposes, which, unfortunately, means that they can only be offset with net capital losses of up to $3,000.
To do so, the tax code states that you must first net out any short-term capital gains and short-term capital losses (these would be gains and losses from investments you’ve sold, not from mutual-fund distributions). Then, you net out any long-term gains and losses (from investments you’ve sold and/or mutual-fund distributions). This can help reduce the amount of the capital gains distributions you receive, thus lowering the taxes you owe on them (see Example 3).
Example 3: Use net capital losses to offset short- and long-term capital gains distributions
An $8,000 short-term capital gains distribution from DEF Growth Fund.
A $500 long-term capital gains distribution from GHI Growth Fund.
You also redeemed JKL Growth Fund at a capital loss of $4,500.
You have no other income for the year.
First, offset the $500 long-term capital gain with the $4,500 long-term capital loss. You’re left with a net capital loss of $4,000.
You still have $8,000 in short-term capital gains, which are considered ordinary dividends for tax purposes. Tax rules allow you to use up to $3,000 of your $4,000 net capital loss to offset your ordinary income, reducing your income to $5,000.
You can carry the remaining $1,000 in net capital losses forward to future tax years.
Talk Like Uncle Sam
Record date: To be eligible to receive a dividend or capital gains distribution, you must be registered as a shareholder before this date, which the fund company will disclose.
Ex-dividend date: Typically two business days before the record date, this is the final cut off to be eligible for a dividend or capital gains distribution.
Payable date: The actual day the dividend or distribution is paid to eligible shareholders.
Wash-sale rule: An IRS regulation aimed at preventing investors from selling an investment at a loss and then replacing it with a substantially similar investment for the sole purpose of earning a tax write-off.
Long-term capital gain: If a security was owned for one year or more, it’s considered a long-term gain. These are taxed at a lower rate, either 0%, 15%, or 20%, depending on your income.
Short-term capital gain: If a security was owned for less than a year before it was sold, the profit from the sale is considered a short-term gain. These are taxed the same as your ordinary income (i.e., your wages, salary, etc), from 10% to 37% as of 2020.
Qualified dividend: Issued by a US company or foreign company that trades on a major US exchange. They are taxed at either 0%, 15%, or 20%.
Ordinary dividend: These are payouts from bank deposits, employee stock ownership plans, or capital gains distributions. They are taxed at the same rate as your ordinary income.
Net capital losses: Excess capital losses from offsetting all short-term capital gains and losses with all long-term capital gains and losses. A maximum of $3,000 in net capital losses can be used to offset ordinary income each year.
In a year with strong performance, it can be helpful to use losses to offset gains and avoid a tax burden from gains. But that doesn’t mean tax-loss harvesting is only for bumper years. In a down year, if the amount of your capital losses exceeds your capital gains distributions, you can also carry unused net capital losses forward to future years.
Your Next Steps
If you own mutual funds in non-qualified accounts, be on the lookout for capital gains distributions estimates and a calendar of important dates from your fund company. These can help you understand what to expect in terms of amounts, and allows you time to prepare your strategy.
Tax-loss harvesting is complex, so it’s best to work with a financial professional and/or tax professional. Since capital gains distributions crop up near the end of the year, it can be beneficial for you and your professional to have a broader portfolio-rebalancing conversation. You can evaluate what is and isn’t working in your overall portfolio. This way, you can not only benefit from a tax standpoint, but also help make sure your portfolio is still diversified and on-target for your long-term goals.
Talk to your financial professional about your capital-gains liabilities and whether tax-loss harvesting makes sense for you
Important Risks: Investing involves risk, including the possible loss of principal. Diversification does not ensure a profit or protect against a loss.
All information provided is for informational and educational purposes only and is not intended to provide investment, tax, accounting or legal advice. As with all matters of an investment, tax, or legal nature, you and your clients should consult with a qualified tax or legal professional regarding your or your client’s specific legal or tax situation, as applicable. The preceding is not intended to be a recommendation or advice.