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DiMeo Schneider & Associates

Financial Planning

Mutual Fund Year-End Capital Gains Distribution

November 20, 2019

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.

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

Practical Considerations:

Be Informed – review year-end distribution estimates for mutual fund positions held within taxable accounts. Pay particular attention to funds which might produce a sizable short-term capital gain dividend, as short-term distributions are taxed unfavorably as ordinary income.

To Sell or Not to Sell? – For mutual funds which will produce notable year-end capital gain dividends, compare the holding’s current unrealized gain or loss against the dividend distribution estimate.

If the mutual fund position has an unrealized loss – sell the position ahead of the record date and consider temporarily replacing with an index fund. [Special Note: Hold the index fund position for at least 31 days to avoid a wash sale.]

If the mutual fund position has a modest unrealized gain – compare the unrealized gain against the dividend estimate and determine if there would be a tax savings by selling ahead of the dividend record date.

If the mutual fund position has a large unrealized gain – there would likely be greater tax savings by continuing to hold the position rather than selling in advance of the distribution.

Be Careful with Year-End Purchases – when contemplating late year investments, be careful when adding to actively managed funds which might produce a year-end capital gain dividend. In such an instance, investors may benefit from temporarily investing in an index fund and subsequently swapping from an index fund to an actively managed fund in January or February of the following year.

Consider Charitable Giving – many taxpayers complete a notable portion of charitable giving late in the year. For mutual funds which are scheduled to pay significant year-end capital gain distributions, charitably inclined taxpayers might consider gifting long-term, highly appreciated shares ahead of the dividend record date. In doing so, the taxpayer receives a tax deduction for the charitable gift and avoids capital gain dividends on the gifted shares. [Special Note: The charitable giving landscape has changed considerably due to the Tax Cuts and Jobs Act of 2017. Taxpayers should check with their tax preparer to determine if this would be an effective strategy in light of changes to itemized deductions and the standard deduction.]

2019 Observations:

Many actively managed equity funds are paying out year-end capital gain distributions, which is not surprising given strong market performance as well as significant 2019 outflows from equity funds, which thus require funds to sell underlying securities to meet investor redemptions.

Year-end capital gain distributions appear to be most common among actively managed U.S. equity and REIT funds.

Factoring in robust 2019 returns for global equities and REITs, it is unlikely that an investor would benefit by selling ahead of the distribution date, as chances are good that a holding’s unrealized gain far exceeds the amount of the year-end capital gain distribution.

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