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Can you remember how you felt two years ago? Hard to believe now, but it was a very dark time for the U.S. financial markets as the Federal Reserve’s crusade against inflation resulted in a record destruction of wealth. The “bear market” erased almost $13 trillion in market value from stocks, while supposedly “safe,” investment-grade bonds shed almost $3 trillion.
Bear markets (drops of more than 20%) are an unpleasant but normal part of your investment journey. In difficult times, the hardest thing for long-term investors to do is to do nothing. Investors who “did nothing” have been amply rewarded for their fortitude, as the S&P 500 is up a whopping 67.8% from its bear-market low on Oct. 12, 2022, and has closed at an all-time high 50 times so far in 2024.
Hopefully, election anxiety didn’t cause you to sit on the sidelines, as you would have missed the best presidential election year for the S&P 500 since 1936. Further, this is one of only 18 years since 1928 when the S&P 500 was up more than 20% at this point in the year. In the prior 17 observations, the S&P 500 averaged a rest-of-year gain of 3.26%, with positive returns 15 times (88.2%).
With this constructive backdrop, you want to jump into stocks for a possible “Santa Claus” rally. Mutual fund investors need to be careful, as most funds will soon be making year-end distributions of realized capital gains, which are taxable on fund shares not held in retirement accounts, like 401(k)s or IRAs.
Like any investment owned in a taxable account, if you sell your mutual fund shares at a profit, you’ll owe capital gains taxes on the difference between the “proceeds” (the dollar amount you received) and the “cost basis” (the amount you paid).
However, taxable mutual fund investors can also incur capital gains taxes even if they don’t sell a single share. Because U.S. mutual funds don’t pay taxes and are thus required to “distribute” realized capital gains and income to shareholders at least annually, unwary investors could face an unpleasant surprise.
Funds sell securities for a number of reasons (like prices being up 70% in two years). Regardless of the reason, the fund realizes a capital gain or loss on each sale, based on the difference between the proceeds and cost.
At least annually, mutual funds tally their realized gains and losses. If there is a net gain, that amount is “distributed” to shareholders. These distributions typically occur in December. If there is a net loss, that amount is “carried forward” and used to offset gains in future years.
A fund calculates its capital gains distribution by dividing the total dollar amount of net gain by the number of shares outstanding on the “record date.” Assume XYZ Fund has assets of $100 million, 5 million shares outstanding on the record date of Dec.16, 2024, and a net capital gain of $20 million. XYZ Fund has a net asset value (NAV) of $20 per share ($100 million of assets divided by 5 million shares) and will distribute $4 per share in capital gains ($20 million net gain divided by 5 million shares) on the “ex-dividend” date of Dec. 17, 2024.
The distribution automatically and immediately causes Fund XYZ’s NAV to drop (Don’t worry!) by the same $4 per share to $16 per share (($100 million assets minus $20 million capital gain distributed equals $80 million) divided by 5 million shares).
Shareholders usually elect to reinvest the distribution in additional shares of XYZ Fund (at the new $16 NAV), but even if you don’t take the distribution in cash, you still owe the tax. So, if a shareholder owns 5,000 shares worth $100,000 (5,000 shares times $20 NAV) on the record date, she can either take a check for $20,000 ($4 per share distribution, reducing the value of her investment to 5,000 shares times $16 NAV equals $80,000) or reinvest the $20,000 in 1,250 additional shares ($20,000 divided by $16 NAV equals 1,250), leaving the value of her investment constant (6,250 shares times $16 NAV equals $100,000).
The potential tax pitfall is, you receive the same $4 per share distribution whether you owned the shares of XYZ Fund one day (and benefited from NONE of the gain) or 10 years on Dec. 16, 2024. While the distribution is a non-event from an investment point of view, it can be a very big deal for taxes. Because of this, taxable shareholders should think twice about buying shares of a fund ahead of a large distribution (greater than 10% of NAV), like XYZ Fund’s distribution ($4 per share distribution equals 20% of $20 per share NAV).
Funds post estimates of upcoming distributions on their websites. Alternatively, Mark Wilson’s CapGainsValet website tracks estimated fund distributions for 439 fund firms (156 of which have posted estimates). The most recent tally had 207 funds with distributions between 10% and 19% of NAV. Wilson’s “doghouse” was populated with 17 funds with distributions between 20% and 29% of NAV and eight funds with distributions exceeding a bodacious 30% of NAV.
Check the estimated distribution of the fund you are considering before buying, or the Grinch might leave an unexpected lump of coal in your stocking.•
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Kim is Kirr Marbach & Co.’s chief operating officer and chief compliance officer. He can be reached at 812-376-9444 or mickey@kirrmar.com.
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