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In this brutal year for the markets, some mutual fund investors face a double whammy: big losses and big tax bills.
This is because fund managers have to give up their money and sell holdings to raise money to pay investors. That often triggers taxable capital gains charges for remaining investors.
“This is a salt-wound year. When you lose money, you owe taxes, and you have less money to carry forward,” said Mark Wilson, financial advisor at Mile Wealth Management, who tracks large mutual fund distributions at CapGainsValet.com.
This issue affects people who hold mutual funds rather than tax-deferred retirement plans like IRAs and 401(k)s. Individual tax bills can vary, but some can be large. According to Mr. Wilson’s research, about 350 funds will pay more than 10% of their net assets this year, and more than 60 will pay more than 20%. Most of these funds have double-digit losses for 2022.
The 20-percent includes funds from well-known firms such as Morgan Stanley, Neuberger Berman, Pimco and JP Morgan.
One of the biggest single payouts is the Delaware Permanent Equity Income Fund, which changed its strategy in 2022 and estimates it will pay out 88% of its net assets to residual investors this year. The parent, the Delaware Fund at Macquarie, has five funds expected to pay off 20% or more of their net assets this year. A spokesman declined to comment on the broadcasts.
Here’s what’s behind the big payouts: By law, mutual fund managers can sell holdings that have fallen in value and avoid capital losses to offset future capital gains on holdings that have appreciated. However, they must remit all net capital gains that are not offset by losses each year to current investors.
After years of strong markets, many managers have had few losses this year to offset gains made on the selling of winners. So when fund holders sold as the market went, the managers often had to sell the winners to meet redemptions – and the capital gains on the sale were distributed among the remaining fund holders.
Of course, the payouts can be in cash—so fund owners don’t need to come up with cash for taxes unless they put the payouts back into the fund. But many reinvest, and either way fund owners owe taxes on assets that shrink when the market declines.
Is this unfair? That’s how Ed Abahoonie, a retired CPA living in Sparkhill, NY, who owns a mutual fund in taxable accounts with big payouts this year.
Share your thoughts
Have you been hit with a surprising tax bill from a mutual fund? Join the discussion below.
This is an unusual outcome because investors have no control. “It’s like hitting when you go down,” he says.
On the other hand, this year’s tax cuts are long overdue. “When funds are growing in value and managers are not selling, there are often tax-related benefits and fewer distributions,” said Brian Schultz, a tax and investments specialist at accounting firm Plant Moran.
Affected investors will soon have to decide how to handle these payments, or whether they will be left with a surprise tax payment liability. Here are some activities to consider.
See where you stand
Investors with taxable accounts in mutual funds should check the expected payouts and dates this year. Funds send notices, but they are usually on the fund’s website. Or call Investor Relations.
Note that capital gains charges are either short-term or long-term. Also check your cost basis in the fund, which is usually the purchase price plus any reinvestment. It is the starting point for measuring your own profit or loss when trading stocks.
Evaluate the options
A good move for investors who want to exit funds that are often net loss is to sell before the maturity date. The tax picture will be particularly complicated for those who hold funds for less than six months and sell them after the profits are paid out, Mr. Schultz said.
Investors with small profits in popular funds expecting high payouts may want to sell and buy back before the distribution, he added. This method, known as a “skip,” avoids tax on capital-gains payments. Wash sale rules (see below) do not apply to sales with interest.
Investors who plan to make a charitable donation to a fund that still has profits should consider doing so before the payout to avoid the tax.
Sell other losers to make a profit
Investors who expect long-term capital gains payments may want to sell elsewhere in their portfolio to offset the gains, especially if the payments have already occurred. As long as it is an investment asset, the loser should not be a mutual fund.
Special: According to Mr. Wilson, short-term capital gains paid to investors by mutual funds cannot be offset by other investment losses, because the law treats them as ordinary income.
Avoid bath sales
If an investor repurchases a holding, such as a mutual fund, 30 days before or after it is sold at a loss, “wash sale” rules delay the use of the loss. However, it is okay to buy similar but not identical currencies within that window.
Rethink property location
Both Mr. Wilson and Mr. Schultz advise clients not to hold actively managed equity funds in taxable accounts because of the potential for large fees in both markets.
Better candidates for taxable accounts are investments in equity funds, such as exchange-traded funds and index funds, which rarely have large fees.
Write to Laura Saunders at [email protected]
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