A mutual fund tax problem and how to avoid it


This year, in a bear market, you may have to pay tax on the putative appreciation. Here’s what to do about it.

A blow for Columbia Integrated Large Cap Growth Fund investors: They’ve been slaughtered this year, down 22% so far, and now they’re going to have to pay taxes on a huge dollop of supposed capital appreciation amounting to 40% of their accounts.

These miserable people have a lot of company. The combination of a bear market, an exodus from actively managed funds, and the peculiarities of fund distributions mean that even in a loss year an investor may owe the IRS a long-term gains tax wad. term.

Morningstar recently highlighted the problem with a chart of funds that plan to make big capital appreciation payments for 2022. Its list of offenders covers dozens of funds from name-brand providers like American Century, Fidelity, Franklin Templeton and T. Rowe Price.

Here, I will explain three things to you:

“How’s the whipsaw tax going?”

—What defensive maneuvers can you use?

—What can you do to prevent future damage from the jigsaw?

The phenomenon only affects taxable accounts. If all the money in your fund is in tax-efficient accounts like IRAs, you can skip to the last paragraph of this story.

1. How does the whipsaw tax work?

There is at least some rationality in the way the tax code treats funds. Starting point: The fund does not pay tax per se, so any gains it makes from stock appreciation must be passed on to the fund’s shareholders, and they must report those gains on their tax returns. income.

Example A: You buy a fund unit for $20. All the stocks in his portfolio double, so now your share of funds is worth $40. The portfolio manager sells some of the winners, enough to generate a long-term gain of $4 per fund unit. The tax code says that $4 will be paid to you by the end of the year. At that point, your fund share decreases in value to $36, you have $4 in cash, and you owe tax on the $4.

The tax bill is unpleasant, but you can’t complain. You are in the same situation as if you had bought the same shares yourself and then sold some of them.

Key point: It doesn’t matter if you reinvest the $4 into the fund. You owe the same tax.

Example B: Same fund buy at $20, same double at $40, but then the bear market comes and the fund value drops to $30. Once again, the manager reduces certain positions and realizes gains equal to $4 per fund unit. Earnings are donated. Your fund share decreases in value to $26 and you have $4 in cash and also a tax bill.

Unfair? Not really. You owe tax at the end of a bad year, but you’re still ahead of the fund share and you have that money too.

Example C: You arrive late and buy the fund unit for $40. The fund collapses to $30. The manager sells some winning positions acquired long before you arrived. Gains are distributed equally among all shareholders. So you end up with a tax bill, even though you’re underwater.

This is when you are motivated to write to your MP.

It’s getting worse. Suppose that half of the shareholders of the fund leave before the distribution takes place. They receive $30 per share in cash and have no long-term earnings distribution to put on their tax return. It doesn’t matter to them. Those who bought at $20 have a profit of $10 and report it on Schedule D. Those who bought at $40 have a capital loss of $10 and report it.

But if you stay, you suffer. The tax code stipulates that all gains made by the fund must go out. None of this is attributed to outgoing customers. So it all lands on the shoulders of the surviving fund clients. With half of the shareholder base gone, the survivors find themselves with distributions of not $4 per share, but $8. If you bought at $40, you end up with a fund share worth only $22, plus $8 in cash, plus a bad tax bill.

You probably can’t blame the portfolio manager for that. He may have sold appreciated stocks not to buy new stock, but to raise funds to pay back departing customers. Mark Wilson, who tracks unwanted distributions at CapGainsValet.com, points out that much of the tax damage happening this year is caused by redemptions.

Note: I am simplifying the calculations in Example C by assuming that all remaining shareholders reinvest all of their payments. If they don’t, the damages would be worse than $8.

#2. What defensive maneuvers can you use?

In examples A and B, the correct answer is to stand. Selling the fund would make things worse for you. You will have to pay tax on both the distribution of the gain and the gain on the fund share.

In example C, however, it makes sense to exit. Your tax return would show a distribution of $8 and a loss of $18 on the fund share (bought at $40, sold ex-dividend at $22). Net capital loss: $10.

Could you improve your lot by leaving just before the distribution? No. You would have the same loss of $10 (bought at $40, sold at $30).

What if you bought the lousy fund less than 12 months ago? This raises the interesting prospect of receiving $8 of long-term gain (the most desirable type of gain) while recording a short-term loss of $18 (the most desirable type of loss).

It would be good arbitrage if you could get away with it, but you can’t. A provision of the tax code states that, in this example, the first $8 of your short-term loss on the fund share is converted into a long-term loss. So whether you leave before or after the distribution, you end up with a short-term loss of $10.

Example D: You bought the fund at $21, saw it rise to $30, and then received an unwanted distribution of $8. What’s best now?

If you exit, you will have $9 of capital appreciation on which you will have to pay tax ($1 from the sale of the fund share, $8 from the distribution of gains). If you stick with it, you’ll have to pay tax on just $8 of the gain, but you’ll face a future littered with more unwanted distributions. My advice: bite the bullet. Sell ​​the fund, paying a little extra tax now, then invest the proceeds in another type of equity fund that won’t give you distributions. This different type of fund is described in section 3 below.

To summarize: if your share of funds, after the payment, is worth much more than what you paid, stay in the fund. If it’s worth less than what you paid, or only a little more, walk away. And it doesn’t matter if you leave before or after payment.

One last point, to answer the fussy people who say that sometimes it matters whether you sell before or after a payment. If the fund has short-term gains, it is better to sell before the payment. Example E: You bought the fund at $20 a few years ago, it’s now worth $21, and it’s about to earn $1 in short-term gain. It turns out that short-term gains from an investment company show up on your tax return as ordinary income, similar to interest income. (Totally unfair; write your congressman.) In this case, selling early means the $1 will instead be taxed at the favorable long-term rate.

However, please note that distributions of short-term gains other than picayune amounts are quite rare. Mutual fund short-term gains are simply not worth losing sleep over.

#3. What can you do to prevent future damage from the jigsaw?

A common refrain among advisors is this: don’t get into an equity mutual fund near the end of the year because you could buy a distribution you don’t want.

I think this advice is too weak. Here’s mine: Never buy a stock mutual fund for a taxable account.

Instead, do what many trillions of dollars of smart money have recently done, which is invest in exchange-traded funds that track indexes like the S&P 500. Equity index funds organized as ETFs almost never make capital appreciation distributions.

Sad truth: Active equity funds collectively underperform index funds. If you must try to beat the odds by owning an active stock fund, put it in your IRA.

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