I Didn’t Sell- Why do I have Mutual Fund Capital Gains?
Each November the majority of mutual fund companies announce and distribute capital gains to each of their shareholders. Capital gains are realized anytime you sell an investment and make a profit.
And, yes this applies to all mutual fund shareholders even if you didn’t sell your shares during the year. I admit it can be confusing, but it all has to do with how mutual funds are structured.
Give my regards to the chef
Let’s forget we are talking about mutual funds for a minute and picture your favorite restaurant. The chef creates the menu and selects the ingredients for each of the dishes. As a patron of the restaurant, you are paying for their expertise and ability to create the perfect dish. The chef makes the decisions, puts it all together and serves their masterpiece. Voilà!
Mutual funds work in a very similar way. They are created by pooling together dollars from investors. These dollars are then used to buy a collection of ingredients like stocks, bonds, and other investments. The person who makes the decisions on what to buy or sell is the fund manager or “chef”. This pool of investments is then divided into shares or portions and “served” to the shareholders. At the mutual fund restaurant, there are no special requests and no ingredients can be eliminated. Everyone gets the same dish.
As a mutual fund shareholder, you are entitled to profits the fund makes. Capital gains are generated when the manager sells a position for a profit. These gains are then passed on to you. In other words, it’s all based on what decisions the manager or “chef” makes. In fact, funds generating a profit are required to distribute them at least annually to avoid paying taxes themselves.
So what can you do about it?
Do your research- avoid managers that buy and sell incessantly
It’s possible to select funds with low turnover. This means the manager does not buy and sell often within the fund. This information is provided by the fund and stated as the turnover ratio. For example, a turnover ratio of 50% means half of the investments in the fund have been replaced during the year. Make sure to look at the fund’s website for this information.
Sell your fund before the capital gains distribution takes place
This is definitely an option but remember, you will want to evaluate whether or not you’ve made a profit on your shares. If you’ve made a profit you will have a capital gain that may be subject to taxes. Also, it helps to evaluate from a bigger picture perspective. Are you selling just to avoid taxes or does the sale make sense in the context of your investments and financial plan?
Hold mutual funds in a retirement account instead of in an individual account
Remember, if you hold a mutual fund in a retirement account like a 401(k) or IRA you don’t have to worry about capital gains distributions. These accounts are taxed at ordinary income (not capital gains) rates only when you make withdrawals.
Select different types of investments
Individual stocks, bonds, and some ETFs do not pass through capital gains. When selling these investments the capital gains are based solely on when you sell.
So yes, it’s possible to have capital gains without selling anything thanks to the “chef”. Normally, capital gains distributions are close to year-end, but the frequency can vary from fund to fund. Check with your fund company for more details.
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Christine Centeno, CFPⓇ, MS is the founder of Simplicity Wealth Management. She has over 12 years of industry experience as a financial advisor and is a member of several professional organizations including NAPFA, FPA, and the XY Planning Network. She also holds her Masters in Financial Planning. In 2019, after years of working for large firms, she founded her own firm. Simplicity Wealth Management provides clarity to the complicated nature of financial planning and investing by delivering comprehensive advice without hidden fees and unnecessary jargon that leaves you in the dark. The goal is to deliver transparent, easy-to-understand guidance to help clients achieve their financial goals and remain informed every step of the way.
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