The stock market in the U.S. has gone up over the past few years, although it has been relatively flat so far in 2015. This could mean that many mutual funds that invest in U.S. stocks may have capital gains distributions again this year. During the month of December, most mutual funds pay out dividends and capital gains that they have built up during the year to holders of the fund.
Investors who have held the fund over the whole year may have a capital gain in their position, and if so, it doesn’t make sense to try and sell the fund to avoid the distribution because it would trigger a capital gain anyway. However, for investors who have recently bought the fund, it is possible to get hit with a capital gains distribution for gains that the fund had, but that they may have not experienced. Even worse, it is possible that a fund has a capital gain for a year (from selling their winners), but the fund actually has a negative return (from keeping the losers). It’s always frustrating to pay capital gains taxes on a distribution when your position has a loss for the year. This could be a case in which it would be recommended to sell a losing position to realize the loss, offsetting capital gains now and possibly in the future. We call this tax loss harvesting.
It is important to be aware of these factors when investing in mutual funds in non-retirement accounts near the end of the year. If you do have to pay capital gains (especially if they are very modest), these could serve to increase your cost basis if you sell down the road. Also, if capital gains distributions are going to be minimal, it could be better to be invested rather than waiting since a market movement could end up being more impactful than the tax consequence of missing the capital gains distribution. You have to be tax aware, but you should not let tax decisions dictate everything. It is generally better to avoid buying funds with big projected capital gains distributions at year-end and utilize funds that are tax-conscious with how much activity they have, as this can not only save from unwanted taxes, but could result in better performance over time as well.
As you can tell, it’s not always a black or white decision when deciding how to handle these year-end tax issues. Luckily, your advisor at Bridgeworth knows these issues and can help you navigate and implement the appropriate measures.