Many investors who hold mutual funds in taxable accounts, rather than a Roth IRA or 401(k), could be in for a nasty surprise during next year’s tax season. Despite the market having moved sharply lower, mutual fund investors may owe significant capital gains taxes on those losing positions thanks to the unique structure of mutual funds.

The good news is that tax-managed funds can avoid these tax pitfalls. Investors may want to consider allocating some of their portfolio to these alternatives in order to mitigate the risk of unexpected tax exposure in 2020 and beyond.

Let’s take a closer look at how mutual funds are taxed, why they could incur surprise taxes and how tax-managed funds can help reduce that tax exposure.

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Mutual funds are simply a basket of assets overseen by a professional money manager. They pay out dividends, capital gains and other income to their owners each year on a pro-rata basis. The fund owners must then pay ordinary income or capital gains taxes on these distributions each year if the funds aren’t held in tax-advantaged accounts.

There are two relevant types of capital gains:

• Sale of Shares: Fund owners pay short-term or long-term capital gains taxes if they sell shares of a mutual fund. For example, if you sold $10,000 worth of mutual fund shares, you would owe capital gains tax on that amount.

• Embedded Gains: Mutual funds that sell stocks or bonds for a gain pass on these capital gains to fund owners. For example, if the fund sold $10,000 worth of stock, you would owe capital gains tax on that amount even if you didn’t sell your shares.

During normal market conditions, professional money managers maintain long-term positions and fund owners only pay tax on dividend income and minor portfolio rebalancing transactions. These taxes are minimal, assuming the funds don’t experience any capital outflows, and most investors hardly notice them each year when paying their taxes.

The COVID-19 outbreak has already sparked panic-selling on the part of fund owners. As fund owners sell, money managers must sell investments in the mutual fund to generate the cash needed to pay those investors. These redemptions trigger capital gains taxes that are passed on to the remaining fund owners that haven’t sold anything.

In some cases, fund owners may be forced to pay large amounts of tax on shares that they have only owned for a short period of time. They could have purchased the fund a few weeks ago, realized a large loss during the timeframe, and still be responsible for paying capital gains that have accrued over the past five years or more.

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The most obvious solution to this problem is to never purchase a mutual fund outside of a tax-free or tax-advantaged account, such as a Roth IRA or 401(k) – and if you do, don’t buy a mutual fund before a distribution in a taxable account. However, there are many cases where investors want to hold mutual funds in taxable accounts.

Tax-managed mutual funds are another option to avoid these situations while still holding mutual funds in taxable accounts. Professional money managers for these funds focus on minimizing capital gains distributions using a variety of different tax strategies.

Some ways they reduce tax exposure include:

• Tax Loss Harvesting: The funds sell losing positions on a regular basis to realize losses that can be used to offset capital gains in other parts of the portfolio.

• Tax-Advantaged Securities: Municipal bonds generate interest payments that aren’t subject to federal income taxes, which reduces the overall portfolio’s tax burden.

• Investor Control: Tax-managed funds enable investors to control when they realize capital gains, such as during a low income tax period when their tax rates will be lowest.

Many mutual fund companies offer tax-managed funds that hold a variety of different assets, such as balanced funds, international funds, small cap funds and others.

Popular tax-managed funds include:

• Vanguard Tax-Managed Small Cap Fund Admiral (VTMSX)
• T. Rowe Price Tax-Efficient Equity Fund (PREFX)
• Vanguard Tax-Managed Capital Appreciation Fund Admiral (VTCLX)
• Russell Tax-Managed U.S. Mid & Small Cap Fund (RTSCX)

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Investors may want to consider transitioning their taxable assets into tax-managed funds to mitigate the potential tax consequences from the COVID-19 outbreak. If panic selling continues, mutual fund owners could be on the hook for significant capital gains tax exposure. Typically, investors should focus on maintaining the following structure to maximize their after-tax return.

When it comes to timing, investors should wait until after the ex-dividend date to buy into a mutual fund, so they avoid paying tax on dividends and capital gains accrued before they become an owner. Sellers should similarly sell before the ex-dividend date to realize a lower capital gains tax rate than they would selling after the ex-dividend date.

Investors may be in for a tax surprise at the end of 2020 as the COVID-19 outbreak leads to panic selling of mutual funds. In preparation, investors may want to consider transitioning their taxable accounts into tax-managed funds or other investments that have less tax exposure.

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