Clients who've sustained big portfolio losses in this year's tumultuous financial market do not want to take a tax hit, too. But as mutual funds prepare to make capital gains distributions, advisors should consider alerting clients to this issue and discussing potential moves to mitigate their tax bills.
Mutual fund companies have started posting estimates for the 2022 capital gains distributions they plan to make before year-end, according to a column posted last week by Stephen Welch, manager/research analyst of equity strategies for Morningstar Research Services. Plus, several funds that sustained big losses have already indicated they'll make significant distributions, he points out.
Morningstar listed 24 major fund families that estimate they'll make moderate to large capital gains distributions between late November and Dec. 31.
Source of Gains
While 2022 certainly has been rocky for investors, Welch wrote, "many funds entered this year holding appreciated assets from a strong 2021 and the long bull market before 2020."
This year's selloff triggered fund outflows, and many investors replaced actively managed stock funds with passive exchange-traded funds. As a result, some fund managers have had to realize capital gains to meet redemptions, he explained.
"A lot of these funds have seen redemptions as the stock market has decreased in value … meaning that they have to sell off assets to meet cash demand," he told ThinkAdvisor in an interview Monday. Strong market growth over the past decade, excluding 2022, has translated into capital gains distributions, he adds.
Meanwhile, the Morningstar U.S. Market Index logged a nearly 19% decline this year through Oct. 31.
"Investors with taxable accounts owe taxes on distributed gains even if they reinvested them, unless they've sold losing positions to offset the gains," Welch explained in his article. These concerns pertain primarily to funds held in taxable accounts.
Funds & Tax Deferrals
Mutual funds held in 401(k) or other tax-deferred accounts receive the capital gains distributions, but investors aren't liable for the tax implications until they start taking withdrawals from these accounts, he told ThinkAdvisor. These capital gains distributions are often reinvested back into the fund, but each investor must decide whether or not to do so with his or her holdings.
Actively managed mutual funds tend to have more capital gains distributions, according to Welch. In contrast, most passive mutual funds, which typically track market indexes, don't sell assets throughout the year or make big moves with individual holdings, unless something is rotated out of the index.
And ETFs, which are structured differently from their mutual fund counterparts, generally don't pass along capital gains distributions to investors, who realize capital gains only when they sell appreciated shares, Welch said.
