If you own a stock-mutual fund, you may face a double whammy this year.
First, the value of your mortgage has declined relative to the overall market.
When shareholders leave mutual funds during a market slide, managers are forced to sell shares to get these investors out.
That’s where the second eclipse comes from.
Because these sales generate capital gains on long-term holdings, they result in capital gains distributions to shareholders, who must then pay capital gains taxes.
Morningstar Director of Personal Finance Christine Benz discusses how investors can deal with the issue of capital gains.
One option is to sell the funds before receiving a capital distribution. But keep in mind that when you sell fund shares, you’ll pay capital gains tax on that appreciation if you trade for more than the time you bought them.
One silver lining to this year’s market downturn is that it can actually limit the amount of your capital gains if you sell your shares.
Also, “many of the funds being distributed this year are series distributors,” Benz said. “It’s not the first year they’ve had a broadcast. If you were to reinvest those distributions, you could increase your cost basis by the amount of the distribution.
So that reduces your capital gain.
If you really like your fund, it may be worth paying only capital gains tax on the distribution and staying in the fund.
“And remember that you’re getting a credit for these distributions, even though you have to pay taxes in the year you receive the distribution,” Benz said.
“If you’re investing back into the fund, you’re increasing your cost basis. This will reduce the tax payable.
Stick to the basics
It’s better to base your decision on whether or not to keep your funds invested than for tax reasons, Benz noted.
Another option is for investors to sell a fund, but buy the same if they want to retain their exposure to the sold fund strategy.
At this point, he said, “You should be aware of something called the wash sale rule, which means if you buy the same item as the IRS and you do so within 30 days. Sales, you don’t allow the tax loss,” Benz said.
“This means that if you’re switching from an index fund to an exchange-traded fund that tracks the same market benchmark, it’s probably not a good idea in light of the bath sale rule.”
However, it’s okay to get out of an actively managed fund and then into a passively managed entity, Benz said.