Mutual fund capital gain distribution season—a time when mutual fund companies distribute taxable capital gains to their shareholders—is not too far away. Fund firms typically begin publishing information about their impending distributions in early December of each year, and make those distributions to shareholders before year end.

For the uninitiated (or if you simply need a refresher on the arcana of mutual funds and capital gains), mutual fund investors can incur capital gains tax on their holdings in a few different ways.

The first is if they sell their shares at a profit from their taxable accounts. In that case, they will owe capital gains taxes on the difference between their purchase price (or technically, their cost basis, which is the purchase price adjusted for commissions and other factors) and their sale price. When it comes to incurring these types of taxes, mutual funds are just like any other investment type: If you make a profit in your taxable account and sell the position, then you will need to pay taxes (assuming you cannot offset the gain by selling losing securities elsewhere in your taxable portfolio).

But mutual fund investors can incur capital gains taxes even if they do not sell any shares. That happens when the fund itself has sold appreciated holdings and realized a gain; in turn, the fund is required to distribute those gains to shareholders, who in turn must pay taxes on them.

Of late, investors’ exodus from actively managed funds in favor of traditional index funds and especially exchange-traded funds has exacerbated the second type of capital gains distributions for many investors. As active funds have experienced redemptions, their managers have been forced to sell off chunks of their portfolios—including some appreciated holdings—in order to pay off departing shareholders. Adding to the tax pain at funds whose asset bases have shrunk, those gains are spread across a smaller shareholder base. That trend, combined with the long-running strength in the equity market and a decent year for stocks in 2016, in particular, means that this year could once again be a doozy of a capital gains season.

Investors are often admonished not to “buy the distribution”—that is, purchase a mutual fund right before it makes a payout, which guarantees that you will owe taxes on a gain you did not receive. That is a good one, but it is not the only pitfall to watch out for when it comes to mutual funds and capital gains. Here are some other pitfalls and misconceptions to watch out for.

Pitfall 1: Assuming You Will Only Receive a Big Distribution If You Have Had a Big Gain
Mutual funds can only make distributions if they have sold appreciated holdings to sell. However, big capital gains distributions do not always follow periods of good performance; even if the fund itself has posted a loss over the past year, it still may make a distribution if its managers has sold appreciated securities during the period. That is the really stinky part of mutual fund capital gains distributions from a shareholder perspective; you can be on the hook for taxes even if you did not have a gain that year or, worse yet, even if you just bought your shares.

Pitfall 2: Panicking When Your NAV Drops
Invariably when mutual funds begin paying out capital gains, investors often inquire why their fund’s net asset value just tumbled. What is going on with performance, they wonder? In a nutshell, nothing: While a capital gains distribution will cost you, assuming you hold the fund in a taxable account, it is a nonevent from a performance standpoint, particularly if you are reinvesting your capital gains. The NAV drops simply because the fund is distributing part of its gains to shareholders.

Pitfall 3: Putting Off a Tax-Efficient Makeover
As noted above, fund shareholders can get hit with capital gains in one of two ways. The first is if the fund makes a distribution, and the second is if shareholders themselves sell shares of the fund at a profit. For that reason, investors are warned against pre-emptively selling shares of a fund that is about to make a big distribution: While they might be able to dodge the fund’s distribution, they may trigger their own capital gains bill if the fund in question has appreciated over their holding period.

In a related vein, investors who have been hit with multiple capital gains payouts from one of their holdings may put off swapping it for something tax-friendly because they do not want to trigger additional capital gains. The silver lining for investors in this situation is that they have essentially “prepaid” their capital gains taxes, as their cost basis in the holding has “stepped up” to reflect the distributions they have already received.

Pitfall 4: Making Too Much of a Small Distribution
When fund companies publish estimates of their impending capital gains distributions, some express those estimates in dollars and cents. Those numbers can look worrisome in isolation, but do not jump to conclusions without some context. Dividing the fund’s impending capital gains distribution by the current NAV can help you discern how big the payout will be in percentage terms. You can further quantify how the distribution will impact you by considering your current balance. Say, for example, a fund is about to make a distribution amounting to 11% of its NAV and your current holdings are worth $100,000. That means that you would receive an $11,000 distribution; if you are in the 15% capital gains bracket, that distribution would cost you $1,650, assuming you do not have any losers elsewhere in your portfolio that you can use to offset it. (Big capital gains distributions accentuate the value of tax-loss selling.)

Pitfall 5: Assuming a Fund Will Always Be Tax-Friendly
Perhaps you have been reading through the previous list of mutual fund capital gains headaches smugly, never having received an unwanted capital gains distribution and certain you never will in the future. That may be the case if you have got all of your holdings stashed inside of a tax-sheltered account, or if you have gone out of your way to choose investments that are structurally tax-efficient, like broad-market-tracking equity ETFs. All bets are off when it come to other holdings in your taxable account, however. Even if a fund has ultralow turnover, a stable management situation, and a history of ultralow or no capital gains distributions, that can change if there is a trigger—for example, if a new manager comes aboard and upends long-held and long-profitable positions, or if the fund suddenly begins to experience redemptions. Those are key reasons investors seeking tax efficiency on a going-forward basis should look past backward-looking statistics and instead focus on those investments that are apt be tax-friendly because of their structures.


©Morningstar 2016. All Rights Reserved. Used with permission.