While the years-long bull market in equities has undoubtedly been welcomed by almost everyone, it doesn’t come without its share of potential drawbacks.
Gains won’t matter much to investors that hold the lion’s share of their portfolios in IRAs or 401(k)s since those balances grow tax-deferred (or potentially tax-free if held in a Roth). Those holding their stock funds in taxable accounts, though, may be headed for an unpleasant tax bill.
What Are Capital Gains Distributions?
Mutual funds buy and sell securities for the portfolio throughout the year. When securities are sold, they generate a realized gain or loss for the fund. At the end of the year, funds are required to distribute any net realized capital gains to their shareholders.
These capital gains distributions are broken down into short-term – positions that the fund has held for less than one year – and get taxed as ordinary income, or long-term – positions that have been held for longer than one year – and get taxed at the lower capital gains rate.
The reasons for higher capital gains distributions are twofold. Since it bottomed in March 2009 following the end of the financial crisis, the S&P 500 has returned more than 300%. Many mutual funds have built up years of unrealized capital gains that could trigger a significant tax hit when those positions are sold. In addition, you have a broad shift of fund assets moving out of actively managed funds and into passively managed index funds. Combine this pile of accumulated unrealized gains with funds being forced to liquidate positions in order to meet redemption requests and you’ve got a recipe for significant capital gains distributions by these funds.
Capital gains distributions are taxable to shareholders as of the fund’s distribution date. If you’re a shareholder of the fund on this date, you receive the full distribution regardless of whether you owned the fund for one day or for 365.
It’s best to try to avoid making large purchases of a mutual fund’s shares just prior to the distribution date. Buying in right before a large distribution creates a tax bill for a gain that you didn’t get to experience.
Funds That Could Make Large Capital Gains Distributions
Identifying funds that could make large capital gains distributions is a bit of an inexact science, but looking at history can give us an idea of which funds tend to be prone to larger distributions.
Here are four funds that may be in line for big distributions. Click on the ticker for more information on the capital gains distribution analysis offered for each fund.
Fidelity Contrafund (FCNTX) – This fund is one of the biggest and most storied funds in the industry, but lately it’s been walloping shareholders with distributions. The fund has distributed more than $8 per share in capital gains distributions over the past two years.
Buffalo Small Cap (BUFSX) – This might be one of the most tax-inefficient funds around. It has made a capital gains distribution of over $3 per share in each of the past four years, including a mind-boggling $12 per share distribution in 2015.
American Funds Washington Mutual (AWSHX) – This six-decades-old Washington fund has delivered strong returns for shareholders, but lately it’s been delivering tax hits too. Over the past three years, the fund has averaged a capital gains distribution of 4% to 5% of its share price.
Vanguard Explorer (VEXPX) – Since 2013, this fund has distributed more than $36 per share in total capital gains.
Capital gains distributions can end up taking a big chunk of your investment’s return away from you if not managed properly. Even some of the fund industry’s biggest names can be big offenders. Keep an eye on turnover and historical activity, as they may clue you into future distributions.
To learn more about how mutual fund distributions are taxed, check out the Taxation section on our website.
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