“Buy the dip,” but beware of tax pitfalls

0
199

Bespoke Investment Group reported as of the end of September, “the Fed’s crusade against inflation resulted in a record destruction of wealth in dollar terms and an extremely large drawdown in percentage terms.” The “bear market” erased almost $13 trillion in market value from stocks. Supposedly “safe,” investment-grade bonds shed almost $3 trillion, a record in both dollars and percentage. Cumulatively, the total drawdown in market value of the stock and bond markets came in just shy of $16 trillion or just over 20%.

Absent a bodacious post-midterm election bounce and/or late year “Santa Claus” rally, stock and bond mutual funds seem likely to end 2022 in deeply negative territory. Adding salt to that wound, despite these losses most funds will also be making year-end distributions of realized capital gains, which are taxable on fund shares not held in retirement accounts (like 401-Ks or IRAs).

Like any investment owned in a taxable account, if you sell your mutual fund shares at a profit, you’ll owe capital gains taxes on the difference between the “proceeds” (i.e. the dollar amount you received) and the “cost basis” (i.e. the amount you paid).

However, taxable mutual fund investors can also incur capital gains taxes even if they don’t sell a single share. Because U.S. mutual funds don’t pay taxes and are thus required to “distribute” realized capital gains and income to shareholders at least annually, unwary investors who are considering buying shares in a taxable account could face an unpleasant surprise.

Funds sell securities for a number of reasons. Besides sales done for normal portfolio management reasons, a fund may need to sell holdings to raise cash to pay departing shareholders. Similarly, a new portfolio manager may sell holdings to reconfigure the portfolio to her liking. Regardless of the reason, the fund realizes a capital gain or loss on each sale, based on the difference between the proceeds and cost. If the security was held more than a year, the realized capital gain or loss is considered “long-term.” Less than a year is considered “short-term.”

At least annually, mutual funds tally their realized gains and losses. If there is a net gain, that amount is “distributed” to shareholders. These distributions typically occur in December. If there is a net loss, that amount is “carried forward” and used to offset gains in future years.

A fund calculates its capital gains distribution by dividing the total dollar amount of net gain by the number of shares outstanding on the “record date.” Assume Fund XYZ has assets of $100 million, five million shares outstanding on the record date of Dec. 15, 2022 and a net capital gain of $20 million. Fund XYZ has a “Net Asset Value” (NAV) of $20/share ($100 million of assets/5 million shares) and will distribute $4/share in capital gains ($20 million net gain/5 million shares) on the “ex-dividend” date of December 16, 2022.

The distribution automatically and immediately causes Fund XYZ’s NAV to drop (don’t worry!) by the same $4/share to $16/share ($100 million assets -$20 million capital gain distributed=$80 million)/5 million shares).

Shareholders can elect to receive the distribution in cash or reinvest the amount in additional shares of Fund XYZ (at the new $16 NAV); either way you owe the tax. So, if a shareholder owns 5,000 shares worth $100,000 (5,000 shares x $20 NAV) on the record date, she can either take a check for $20,000 ($4/share distribution, reducing the value of her investment to 5,000 shares x $16 NAV = $80,000) or reinvest the $20,000 in 1,250 additional shares ($20,000/$16 NAV=1,250), leaving the value of her investment constant (6,250 shares x $16 NAV=$100,000). Reinvesting the distribution also increases her cost basis by $20,000, which will reduce the realized capital gain when she eventually sells the shares.

Here’s where it gets tricky for taxable shareholders; in this example you receive the same $4/share distribution whether you owned the shares of Fund XYZ one day or ten years on Dec. 15, 2022 (i.e. the record date). While the distribution is a non-event from an investment point of view, it can be a very big deal for taxes. Because of this, taxable shareholders should think twice about buying shares of a fund ahead of a large distribution (> 10% of NAV), like Fund XYZ’s distribution ($4/share distribution = 20% of $20/share NAV).

Most funds post estimates of upcoming distributions on their websites. Alternatively, Mark Wilson’s excellent (and free!) CapGainsValet<https://www.capgainsvalet.com/> website tracks estimated fund distributions for just over 300 fund firms (69 of which have posted estimates). The most recent tally had 168 funds with distributions between 10% and 19% of NAV. Wilson’s “doghouse” was populated with 17 funds with distributions between 20% and 29% of NAV and nine funds with distributions exceeding a whopping 30% of NAV.

This could be a great opportunity to take advantage of lower prices and get some of that $20 trillion back, but as we get closer to year-end, it would be wise to check the estimated distribution of the fund you are considering before you buy.

Mickey Kim is the chief operating officer and chief compliance officer for Kirr Marbach & Co. Kim also writes for the Indianapolis Business Journal. He can be reached at [email protected]

LEAVE A REPLY

Please enter your comment!
Please enter your name here