’Tis the season for taxable dividends and capital gains to show up in your mutual fund account—and on your tax return.
Many publicly-traded companies pay out some portion of their excess earnings to their shareholders, and the aggregate of these dividends are distributed to, and through, the mutual funds that own shares of these companies. Most of the time, the dividends are paid out in late November or early December, and the fund companies are required to pay those cash flows to investors in the fund at least once a year—typically also in late November or early December. Investors can choose to receive the dividends as cash in their accounts, and the share price of the mutual fund drops by same percentage amount as the dividend paid. Or they can establish a dividend reinvestment plan, where the dividend is automatically used to buy new shares of the fund.
Mutual funds are also required to distribute gains if they sell some of their stocks at a profit. If the investment was held for less than a year, the money is taxed as a short-term gain at ordinary income rates; if held for longer than a year, it will be taxed at lower capital gains rates. One of the worst tax traps an investor can encounter is receiving a high capital gains distribution from a fund that actually lost money during the year; it happens if the fund is liquidating some of the stocks that went up in value since purchase, while the rest of the portfolio is declining. In this lose-lose situation, a new investor will be paying taxes on gains that he or she never participated in.
Interestingly, exchange-traded funds (ETFs), which look and act like mutual funds, actually don’t have these tax problems. When the manager of an ETF wants to make a trade, he or she can offer shares ‘in kind’ to authorized traders. No actual sale means no capital gains. Better yet, the ETF issuing company (or manager) can pick and choose which shares to swap out, which means they can offer shares with the lowest tax basis, leaving the ETF holding only shares purchased at or even above the current market price.
Of course, when the investor sells mutual fund or ETF shares, the gain or loss is a taxable event in and of itself. Many experienced advisors will spend this time of year poring over the expected distributions and any holdings that have losses, and sell them, ‘harvesting’ the losses and avoiding the taxable distributions—which is one way to reduce the tax bite come April.
Sources: https://www.investopedia.com/ask/answers/091715/how-often-do-mutual-funds-pay-capital-gains.asp https://www.investopedia.com/news/etf-open-secret-theyre-tax-loophole/ Registered Representative and Financial Advisor of Park Avenue Securities LLC (PAS). OSJ: 5280 CARROLL CANYON ROAD, SUITE 300, SAN DIEGO CA, 92121, 619-6846400. Securities products and advisory services offered through PAS, member FINRA, SIPC. Financial Representative of The Guardian Life Insurance Company of America® (Guardian), New York, NY. PAS is a wholly owned subsidiary of Guardian. LIVING LEGACY FINANCIAL INSURANCE SERVICES LLC is not an affiliate or subsidiary of PAS or Guardian. Insurance products offered through WestPac Wealth Partners and Insurance Services, LLC, a DBA of WestPac Wealth Partners, LLC. CA Insurance License Number - 0F64319, AR Insurance License Number - 9233390. | 2022-147730 Exp. 12/24 | This article was written by an independent third party. It is provided for informational and educational purposes only. The views and opinions expressed herein may not be those of Guardian Life Insurance Company of America (Guardian) or any of its subsidiaries or affiliates. Guardian does not verify and does not guarantee the accuracy or completeness of the information or opinions presented herein. Guardian, its subsidiaries, agents and employees do not provide tax, legal, or accounting advice. Consult your tax, legal, or accounting professional regarding your individual situation. This material is intended for general use. By providing this content Park Avenue Securities LLC and your financial representative are not undertaking to provide investment advice or make a recommendation for a specific individual or situation, or to otherwise act in a fiduciary capacity. Past performance is not a guarantee of future results. All investments contain risk and may lose value. Equities may decline in value due to both real and perceived general market, economic and industry conditions.