Owning a mutual fund that's down 20% or 30% is bad enough. Now, holders of many money-losing investments will be asked to pay capital gains taxes, too.
The gains come from managers buying and selling securities inside the portfolio over the past year. If they sold a stock they'd owned for a long time, they may have a big gain on it — even if that stock, and the broader fund, are down this year.
Say a fund bought a stake in Meta Platforms in 2014, back when it was known as Facebook and was trading in the $50s. The stock now trades around $111, so if the fund sold that long-held position it would still have a capital gain, even though Meta has fallen by about two-thirds this year.
As a result, many funds that are down double-digits this year will be distributing capital gains to shareholders, with some as high as 40% or more of the net asset value of the portfolio.
If investors don't have losses in their own portfolios to offset the fund's distribution, and hold the fund in a taxable account rather than in a 401(k) or individual retirement account, they'll most likely wind up paying the long-term capital gains tax rate of 15%-20%.
(Some gains may be short-term, which means they were held for less than a year, and are taxed at ordinary income tax rates.) Tax is owed on gains even if they are reinvested in the fund.
'Tough to stomach'
"It's definitely tough to stomach if you're down overall, and the market is down 20%, and you still get these capital gains distributions," said Stephen Welch, a manager research analyst at Morningstar who is tracking capital gains distributions. While funds are putting up notices about distributions on their websites now, payouts start in late November and run into late December.
A fund's capital gains payout is expressed as a percentage of its net asset value, or NAV, which is the fund's assets minus its liabilities. A distribution of 5% or so is not a big deal, said Welch, but "anything over 10% is where it's starting to matter."
A new Fidelity report showed that despite the pressures of inflation, most people with 401(k)s kept contributions steady in the third quarter.
Capital gains are paid to shareholders on a pro-rata basis, meaning payments are proportional to how many fund shares you own. Say you held 2,000 shares of a fund that had a net asset value of $20. If the fund has a capital gains distribution equivalent to 10% of its NAV, or $2, you'd get $2 for every share you own, or $4,000. A 15% capital gains tax on that would come to $600.
If you sold a security elsewhere in your portfolio for a loss during the year, however, you could offset that gain, up to $3,000. In this case, you would only pay that 15% tax on $1,000 of the $4,000 in capital gains, so $150.
Growth camp
While a lot of big capital gains distributions came from growth-oriented equity funds last year, Welch is now seeing more from value-oriented funds. Among them are Delaware Ivy International Small Cap), with an estimated distribution equal to 46% of the fund's NAV, Delaware Global Value Equity (40% of NAV) and Virtus NFJ Mid-Cap Value (29% of NAV).
In the growth camp, large payments are expected from funds including Columbia Integrated Large Cap Growth Opportunity (about 40%), Delaware Ivy Global Growth (42%) and JPMorgan U.S. Large Cap Core Plus (24%).
Anyone considering buying an actively managed mutual fund toward the end of the year should check the fund website to find the record date for any distributions. That's the date by which an investor has to own the fund in order to get the capital gain or income distribution. You don't want to buy a fund only to be taxed on a gain you didn't enjoy.
