It’s mid-November. Is there anything you can still do to trim your 2019 tax bill?
There very well might be. One overlooked aspect of mutual funds is that they can significantly—though quietly—impact shareholders’ tax returns.
By way of background, mutual funds, including exchange-traded funds (ETFs) are required to pay out to shareholders, on a pro rata basis, all of the income that they generate each year. This includes interest paid by bonds, dividends paid by stocks and capital gains created when the fund sells an investment at a profit.
To provide a simple example, suppose you’re a shareholder in a mutual fund. And suppose that fund bought a share of Apple stock on January 1st of this year, held it for ten months, then sold it at the end of October. How much income would this investment have generated for the fund—and therefore how much would it be required to pay out to you, as a shareholder?
During those ten months, Apple paid out dividends of $3.04 per share. And over that time period—between the purchase and the sale—Apple’s share price increased from $157.92 to $248.76, for a profit of $90.84. As a result, the fund’s total income from this investment was:
Capital gains: $90.84
By law, this fund would be required to pay out that $93.88 to its shareholders by the end of this year (along with the net gains or losses from all of its other investments, and net of operating expenses).
On one hand, this may seem discouraging—to realize that your tax bill is in the hands of your fund manager, who is permitted to buy and sell freely, generating taxes for you. But there are three important facts to know that can help you take back control over this:
1. Some types of funds are far more tax-efficient than others. Broadly-diversified index funds have many well-understood advantages, including strong performance. But a lesser-known advantage is that they are, almost universally, more tax-efficient than their actively-managed peers. Why? Because index funds, for the most part, employ a buy-and-hold strategy. As a result, they don’t experience the same sort of buying and selling as funds run by stock-pickers who are constantly swapping investments in and out. This translates directly into fewer capital gains and thus a lower tax bill for you, the shareholder. This is yet another reason to favor simple index funds like S&P 500 or total market funds.
According to an analysis by the research firm Morningstar, this effect has been amplified in recent years. As investors have moved billions out of actively-managed funds and into index funds, it has put selling pressure on many actively-managed funds. To redeem exiting shareholders, these fund managers have been forced to sell some of their holdings, triggering gains. With the market at new highs, and actively-managed funds losing popularity, I expect this trend to continue.
In many cases, the tax impact of actively-managed funds may be modest. The problem, though, is that it’s entirely unpredictable. In that same analysis by Morningstar, they relate how one well-regarded fund—the Sequoia Fund—ran into trouble. The fund manager had become enamored of a company called Valeant Pharmaceuticals, to the point that it accounted for nearly 30% of the fund’s assets. Unfortunately, Valeant got caught up in a series of scandals, destroying the stock’s value. Investors fled, causing the fund manager to begin selling the fund’s other investments. In the end, the Sequoia Fund has lost nearly half its value since 2015. And to add insult to injury, it has left shareholders with massive tax bills. To be sure, this is an extreme example, but it illustrates why investing in an actively-managed fund is like handing a blank check to your fund manager.
2. Even if you currently own an actively-managed fund, you might still be able to sidestep a big part of the tax bill if you act quickly. I recommend these two steps: First, check the fund company’s website. Around this time of year, many companies publish “distribution” estimates for each of their funds. For example, you can find Vanguard’s listed here and Fidelity’s here. Not only will they tell you the projected size of the distributions, but they’ll tell you the exact date on which they’ll be making those distributions (called the “pay date”). Don’t like what you see? While you would want to do additional homework before making a decision, the good news is that you can avoid receiving your share of a taxable distribution by simply selling the fund before the pay date. Again, you want to be sure to make this decision carefully, to confirm that it aligns with your investment plan and to be sure that it doesn’t generate other, unexpected taxes.
3. Finally, I should note that this discussion applies only to taxable accounts. If you own a fund inside a retirement account like an IRA or 401(k), these kinds of distributions wouldn’t affect you.