Mutual Fund Capital Gains in 2024
Here are some key Takeaways:
– Capital gains distributions can happen even in years when the market is down, as seen in 2022
– Owning mutual funds in retirement accounts (401k, 457 plan) doesn’t have immediate tax implications for capital gains distributions
– In taxable brokerage accounts, capital gains distributions are reportable as taxable income on Form 1099
– ETFs are generally more tax-efficient than mutual funds in taxable accounts
– Capital gains distributions are added to the cost basis of reinvested shares
– Mutual funds update prices once per day, while ETFs are priced continuously throughout the trading day
– ETFs are becoming more popular due to their potential for tax efficiency and potentially lower expenses
Mutual Fund Capital Gains in 2024 – Links
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Mutual Fund Capital Gains in 2024 – Transcript
We’re recording this in the middle of October of 2024, and something that always comes up this time of calendar year in either September or October is capital gains distribution – specifically mutual fund capital gains.
Just as a refresher, when the fund managers of these different mutual funds buy and sell positions – under the hood – under the mutual fund wrapper, the gains get passed along to the shareholders. They are then paid out in what are called mutual fund capital gains distributions.
A big thing to consider is if you own a mutual fund in a brokerage account versus if you own them in a retirement account – like a 401k or a 457 plan.
We’ll get into that a little bit more later.
One of the mutual funds we have noticed has paid out a good capital gain here in 2024 – the market has been good – usually these capital gains happen in good market years.
We did see an instance in 2022 of funds losing money but then also paying out a capital gains distribution. That did not make their owners very happy. But here in 2024, the Fidelity OTC fund – ticker symbol FOCPX – this is NOT a buy OR sell recommendation — but just one that we’ve noticed paid out almost a ten percent mutual fund capital gain distribution to its owners here in 2024, Tom.
It’s kind of cool to look at someone’s account and see $9,000 or $10,000 or twelve thousand dollars hitting an account, out of seemingly nowhere. It’s really nice to see.
I am happy to say the clients who own these kinds of funds (not just this particular one), but clients who own these funds in retirement accounts have nothing to fear. That’s because there’s no taxability – until you take money out of your account, out of your retirement account — not necessarily with the investment.
But as Casey alluded to, it’s in the taxable brokerage accounts where you really have some issues you have to be aware of with mutual fund capital gains.
Why is that?
Well, it’s an unplanned distribution. Meaning it’s not at your control. It’s not like you decided, “I want to sell ten percent of this Fidelity fund and take the money.”
No, the manager made portfolio changes and those capital gains get passed along to you – pretty much at their discretion.
Now there are mutual funds that will have very sizable gains which will make distributions sometimes in June, at the end of the second quarter. Or sometimes like now in September or October. And then there are other funds that will just leave it all until the end of the year. So it’s an issue.
Clients get a Form 1099 for that, they will call us.
That’s what I was getting at. You have to report it as more taxable income on your tax return. Which if it’s substantial, you know, a couple thousand or more dollars, it could move the needle and mean you’re paying more income taxes early next year.
Especially like you said, it’s an unplanned thing where it’s not like you were planning on taking out 10k from your brokerage account and paying the gains on that. But, you know, it is… I wouldn’t say it’s… you made money in the investment, which is a good thing. You’re paying a capital gains tax, meaning you made money on the investment – that’s a good thing. It’s just a little wrinkle in the planning side of things where you’re going to have to potentially pay more in taxes because your investments made money.
So let’s take this a step further.
Suppose you own this Fidelity fund in a taxable brokerage account, and they declare this ten percent capital gain distribution. Suppose you’re reinvesting the shares. That ten percent, or in this case, say you invested a hundred thousand dollars, you get a $10,000 capital gain distribution. You reinvest it.
That ten thousand dollars gets added to your cost basis. It’s not deducted. It’s added to your cost basis.
So let’s say over a period of time this happens, say, three times.
And the fund does a $10,000 capital gain distribution each time. So you started with $100,000.
You had three distributions of $10,000 each.
And you go to sell this in the future. Say it’s worth $200,000.
Your cost basis is $130,000, not the $100,000 you started with.
Big difference. Because you already paid the tax on that money.
It’s important to take that into consideration.
An alternative to owning mutual funds in a taxable brokerage account – this is what I really want to drill down on – is to consider owning exchange-traded funds or ETFs, which we talk about the differences a lot on different videos and podcasts.
The difference is in the tax efficiency. ETFs typically don’t pay capital gains distributions like mutual funds do. You can get similar market exposure. They both own baskets of stocks. They both are very targeted in the market exposure that you’re getting in these investments. So I think the case is pretty clear when it comes to taxable brokerage accounts that ETFs can be a much more efficient way to invest.
There are plenty of mutual fund families who, over the course of the last ten to fifteen years, have realized the trend towards exchange-traded funds, ETFs. And so in many cases, they have built an exchange-traded fund that mirrors what the mutual fund owns. And so you get an ETF that’s a lot more tax-efficient. You don’t have the potential tax exposure that you would have with a mutual fund.
But there’s also usually a difference in the expenses that come with these ETFs – compared to the expenses of a mutual fund and mutual fund capital gains.
Right?
This stat is from a CNBC article where they talked to an analyst at Morningstar. Over the five years from 2009 to 2013, about seventy percent of US stock funds kicked off mutual fund capital gains. Seventy percent. That was true for less than ten percent of US stock ETFs.
It’s just a difference in how they’re structured. It’s a difference in how they’re managed. But I think mutual funds were, you know, they’re still in a lot of these retirement plans. They’re still on the menu of a lot of 401(k) accounts, 457s, and 403(b) plans.
We’re not seeing ETFs infiltrate that space just yet. Although some people are calling for that to happen in the future.
Due to things like expenses – like we referenced earlier but, you know, like I said earlier, I think if you’re owning mutual funds in a taxable brokerage account, I think you may do better from a tax perspective with those mutual fund capital gains and get just about the same market exposure from doing that in an ETF. And you may not have this surprise of the capital gains distribution and potentially paying more in taxes because of that.
That’s a good point. It’s a really good point. And there’s still plenty of folks out there who don’t understand what exchange-traded funds are, what ETFs are. They’re mutual funds that trade on an exchange.
When you invest in a traditional mutual fund, they do not trade on an exchange. And that’s why early in my career, people would say, “I want to put… I want to buy a hundred shares of this mutual fund.” It doesn’t work that way. You have to tell us the dollar amount that you want to invest – because I can’t even tell you today what the price is going to be – because you’re going to get the price after the market closes.
Mutual funds update in price only once per day, whereas ETFs are updated continuously throughout the day. That’s why it’s exchange-traded.
Exactly. So there’s that price discovery element as well, which is another benefit towards ETFs.
Like I said earlier, in 2022, the market was down, but because the market was up in 2020 and 2021, these mutual fund managers peeled off some of those gains. So the price of some of the mutual funds was down. You lost money in the investments and then you got hit with a tax bill on top of that due to the mutual fund capital gains. So at least here in 2023 and now in 2024, we’re seeing gains happening because, you know, the stock market has been good so far this year.
And that’s why we’re seeing these mutual fund capital gains happen. So if you own mutual funds in a taxable brokerage account, you should probably anticipate a Form 1099 at some point in the new year showing the mutual fund capital gains. Make sure to get that over to your tax preparer as they will need that information.
When you have a down year like 2022, the funds usually get a lot of calls for redemptions. And so the fund manager gets forced into selling shares of – whether it’s bonds or stocks. They’re kind of forced into selling the most liquid asset that’s there. And unfortunately, that’s usually something that’s got a nice gain to it.
And so that’s a big reason why you’ll see a year like 2022 – where you’ll have a loss in the value of the fund – but you’ll also get a 1099 for a capital gain distribution. And that just… it’s lousy.
Because you lost money and you have a tax bill that comes with it.
So alright. I think that’s it. Think that’s gonna do it.
Right.
Hey, was I supposed to hit this record button? Just kidding.
