The Challenging Scenario of Mutual Funds Distributions and Taxes

You may get a harsh surprise when you get a tax bill from a mutual fund that lost money.

It’s perfectly legal and has happened in the past too. When and where you hold investments matters a lot when it comes to managing taxes.

Let’s dive in to understand how mutual fund distributions create tax liabilities for you even when you lose money.

Mutual Funds Distributions and Taxes

When you put money in mutual funds and hold them in taxable accounts, you owe taxes when these funds distribute capital gains or dividends.

If you keep your investments in tax-sheltered accounts, then your taxes are deferred usually until you withdraw gains.

Whether you receive gains from mutual funds in the form of cash or reinvest them in the fund, you must report these transactions for tax compliance.

Even if you invest in a fund at the end of the year and the fund makes distributions, you must pay taxes on these gains. So, doesn’t matter when you make the move, if there are distributions, you owe taxes.

The distribution policy of mutual funds largely depends on the type of fund you choose to invest in.

For example, most equity and bond funds make capital gains distributions at the end of the year while most money market funds make monthly dividend income payments.

In any case, if there is a payout in the form of dividends or capital gains, you must report the transaction and pay taxes.

Losses on Mutual Funds and Capital Gains Taxes

A cumbersome situation for most investors arises when their funds make losses and still make distributions through capital gains.

What does that mean to you?

You are making losses and still need to pay taxes? Harsh but true it is.

When there is a long market downturn, mutual fund managers try to rebalance their portfolios. They sell some securities and add newer ones.

Sometimes, the fund management changes its investment policy and they add/remove certain types of securities.

According to the Russel Investments report, the average capital gains distributions were 12% and 7% in 2021 and 2022 respectively, although the market was down 19% in 2022.

This challenging scenario of mutual funds losing money and their shareholders getting a hefty tax bill isn’t a unique one.

Mutual funds hold securities for several years, and when some of these securities peak to their performance potential, fund managers sell them.

It means even when the fund loses money overall, you may receive distributions in the form of capital gains on some of the sold securities.

In other cases, you may receive dividend or interest income even when the fund is losing money collectively.

What If There is No Distribution from Mutual Funds?

Most mutual funds have distribution plans in the form of dividends, interest income, or capital gains distributions at some point in the fiscal year.

However, if a fund doesn’t make any type of distribution, or if the fund makes non-taxable distributions, you do not owe any taxes.

How to Save Money on Taxes from Mutual Funds?

While you can’t avoid taxes, there are legal ways to minimize your tax bill when considering mutual funds and the potential challenges of paying taxes in a downturned market.

Consider Tax-Efficient Mutual Funds

There are tax-efficient mutual funds that promise to lower your tax liabilities rather than increase them.

For example, the T Rowe Price Tax-Efficient Equity Fund invests mostly in growing stocks and plans to avoid capital gains taxes.

You should search and find such tax-efficient funds that invest wisely in securities with better tax benefits.

Low-cost index funds are also viable options as they mirror market performance by tracking all global stocks and bonds in selective categories.

Keep an Eye on Mutual Funds Turnover Ratio

The fund turnover ratio is a key indicator of the sale and purchase transactions of the fund during the last 12 months.

Some funds are actively managed and they tend to make more transactions throughout the year. Hence, their turnout rate may get as high as 80% or even 100% in some cases.

A high turnover rate for a fund means higher management costs and more capital gains taxes for you. So, make turnover rate a key metric in your selection of funds.

Invest Timely in Mutual Funds

Mutual funds disclose their distribution policies in prospectuses. Check them out before investing in a fund.

A common practice is to make capital gains and dividend distributions at year-end. So, make sure to invest wisely and even when you invest at the year's end, you’ll owe taxes.

However, if you wait until the distributions are out, you may lose on investment appreciation opportunities.

Consulting a professional tax advisor can help you make the right call in such situations as you wouldn’t want to lose on handsome long-term gains while avoiding taxes.

Keep Mutual Funds Investments in Tax Efficient Accounts

A widely used tactic to avoid immediate tax bills is to keep your mutual fund investments in tax-efficient accounts.

For example, you can choose certain retirement plans like 401(k), individual IRAs, and Roth IRAs depending on how you plan to pay taxes.

Again, consulting a tax professional can help you make the right call and plan taxes efficiently for the long term.

Consider ETFs - Viable Alternatives to Mutual Funds

Like index funds and passively managed funds, ETFs are a great choice if you want to lower your tax liabilities.

Stock index funds are usually more tax-efficient than most bond or high-dividend stock funds.

ETFs usually make fewer transactions so their turnover rate is lower. Their management costs are also on the lower side.

Overall, if tax savings are your prime goal, you should go for ETFs with better liquidity and tax efficiency.

Keep an Eye on Market Events and Fund Managers

Fund managers may change their investment and distribution policies during the year but they certainly inform shareholders about it.

Fund managers offer indicators and plans on whether they’ll make distributions, dividend payments, or changes to portfolios in the coming months.

Keep an eye on trigger events and avoid investing in funds that are planning large payouts.

Consider Tax-Loss Harvesting

Finally, create an effective tax-loss harvesting plan in a downturn market. Even if you receive capital gains or dividend distributions from your fund, you’ll likely lose money on other securities.

You can offset these losses against capital gains and minimize tax liabilities through an effective tax-loss harvesting plan.