Planning considerations for taxable investors
Mutual funds may recognize capital gains upon selling underlying securities due to a changing outlook for a particular holding or to meet investor redemptions.
Some investors may not realize that mutual funds are required to pass along such capital gains in the form of a capital gain dividend to shareholders. Investors who hold the mutual fund as of the dividend record date will receive the capital gain dividend, regardless of whether the fund has been held for 20 days or 20 years. Taxable investors should have a clear understanding of capital gain distributions and should assess whether any planning opportunities exist prior to a dividend distribution.
Capital Gains Distribution Explained
Most mutual fund families provide estimates for year-end capital gain distributions between October and November, with capital gain dividends typically paid in December. A mutual fund may pay out a combination of short-term capital gain dividends and long-term capital gain dividends, depending on the fund’s realized gains for the year.
Short-Term Capital Gain Dividends
- Produced when a mutual fund realizes a net short-term capital gain
- Does not flow to Schedule D (Capital Gains & Losses) and thus cannot be offset by portfolio realized losses
- Treated as an ordinary income dividend, taxable at ordinary income tax rates
Long-Term Capital Gain Dividends
- Produced when a mutual fund realizes a net long-term capital gain
- Flows to Schedule D (Capital Gains & Losses) and thus can be offset by portfolio realized losses
- Treated as a long-term capital gain, taxable at preferential long-term capital gains rates
Trust Point’s Steps:
- Staying Informed – Trust Point reviews year-end distribution estimates for mutual fund positions held within taxable accounts, paying particular attention to funds which might produce a sizable short-term capital gain dividend as short-term distributions are taxed unfavorably as ordinary income.
- Determining When Selling is Appropriate –For mutual funds which will produce notable year-end capital gain dividends, Trust Point compares each holder’s current unrealized gain or loss against the dividend distribution estimate. If the mutual fund position has an unrealized loss, Trust Point will sell the position ahead of the record date and consider temporarily replacing with an index fund.
- Monitoring Year-End Purchases – When making late year investments, Trust Point avoids adding to actively managed funds that may produce a year-end capital gain dividend. Instead, Trust Point may wait to invest until after the dividend record date, or temporarily invest in a non-dividend paying index fund.
- Year-Round Awareness – While researching new funds to invest in, Trust Point is careful to avoid funds that have high turnover and would consistently generate short-term capital gain distributions. Additionally, Trust Point allocates a significant portion of all models to passive index funds that generate no or minimal capital gain distributions.
- Susan Smith is a high net worth investor and is subject to the highest federal income tax bracket of 37 percent and the 20 percent federal tax rate for long-term capital gains.
- Susan owns $1,000,000 of Fund ABC; the position has a $15,000 long-term unrealized loss.
- Fund ABC will pay out a year-end short-term capital gain dividend of $30,000 and a year-end long-term capital gain dividend of $40,000.
- Potential Taxable Event= [($30k x 37%) + ($40k x 20%)]
- In this example, Susan would save $19,100 from avoiding the year-end distributions, while realizing a $15,000 long-term loss, from selling Fund ABC before the dividend record date.