It's Time to Check Capital Gain Distributions

/ Planning Within Reach/

You may have to pay capital gain tax, even if you didn’t sell any shares of a fund.

Many people learn about capital gain distributions when they file their taxes. Rather than wait for the surprise, I show you how to project your fund’s capital gain distributions and how to decide if you should prepare for the tax impact or take action to avoid it.

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A realized capital gain versus a capital gain distribution

Realized Capital Gains

A realized capital gain results from a sale. When you sell a position in your portfolio for more than you purchased it for, that difference (the market value minus the cost basis) is the realized capital gain. It is “realized” because you sold it. Log into your investment account and you will typically see 2 tabs - “Realized gains and losses” and “Unrealized gains and losses”. Unrealized gains and losses are for the positions that haven’t been sold yet.

Realized capital gains and losses are reported on your tax return. You pay tax on capital gains at either short-term or long-term rates. Short-term gains are for securities that you held for less than a year and the tax rate is the same as your ordinary income tax rate. Long-term capital gains are from securities held for more than a year and their tax rates are more favorable.

Capital Gain Distributions

Capital gain distributions are not the result of you selling a position in your portfolio. It is a gain that is passed onto you by a mutual fund that you own. It is also sometimes described as “phantom” income because you pay tax on it, but you don’t actually receive a check. It increases your basis when re-invested, but your position’s value is the same. With a mutual fund, the manager and his/her team are buying and selling positions throughout the year. When these transactions generate realized gains, they are required to pass the gains onto their shareholders by the end of the year - that’s you!

Capital gain distributions are not a surprise - don’t miss the planning opportunity.

Run an analysis right now (and every year in late November) to pro-actively look up the estimated distributions for the fund’s in your taxable portfolio. This will provide the information needed to help you decide if you should prepare for the tax impact or take action to avoid the distribution. Even if you held the mutual fund all year, if you sell it before it pays the distribution, you do not pay tax on it.

How to project this year’s capital gain distributions.

Fund companies typically post their preliminary distributions in mid-November. If you have Vanguard funds, for example, you can search “Vanguard preliminary year-end distributions”. The list will show the projected capital gain distribution per share for each fund and the percentage of NAV (net asset value). It also lists the “ex-dividend date”. You need to sell by that date to avoid the distribution.

Vanguard, American Funds, Janus, etc. all list their projected distributions on their website. Another source for preliminary distributions is CapGainsValet. This site was started by a fee-only advisor and it includes a free search tool.

  • Create a spreadsheet with every fund you hold in taxable (non-retirement) accounts.

  • Go to the fund’s website or CapGainsValet to look up the projected capital gain distribution.

  • Calculate the dollar amount of the distribution given the value you have in the fund or the number of shares.

Just because you can sell the fund to avoid the gain, doesn’t mean you should.

When you sell, you may be avoiding the capital gain distribution, but you still have to pay tax on the realized capital gain. It would not make sense, for example, to sell a fund every year before the distribution and re-purchase it after the distribution because of the transaction fees, capital gains, and wash-sale issues. If you are holding a fund that you want to hold long-term, look up the capital gain distribution to prepare for your tax bill, but don’t sell.

Here is a situation where you may be a good candidate for selling before the ex-div date:

  • You have a taxable account with active funds. You are transitioning to index funds that have lower turnover and lower costs. You have been making the transition slowly because you have realized gains and will owe tax when you sell. You determine that one of your active funds is planning to pay a large capital gain distribution this year in December. If you sell, you will move the proceeds into a fund that is not paying a distribution.

In this example, selling to avoid the distribution will save you money in taxes and get you closer to your ideal long-term portfolio of index funds.

Here is an example that I worked through with a client:

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  • JACNX was a mutual fund that was in a taxable account for a client. The client wanted to sell it and move it to a Vanguard index fund. They were slowly transitioning their portfolio from active fund to index funds.

  • If she sold JACNX, she wanted to move the proceeds to VTSAX. VTSAX was not planning a distribution.

  • While she would have to pay tax on the sale of JACNX (market value minus cost basis), if she sold before the distribution, she would end up paying less in taxes than if she held onto JACNX.

Make sure that you work with someone who understands tax planning.

You don’t have to worry about capital gain distributions if all of your money is in retirement accounts because those accounts are tax-deferred. And if most of you taxable money is in index funds, you can look up their distributions, but they are likely very small or non-existent because index funds have less turnover than active funds.

Tax planning is an extremely important part of financial planning. Work with an advisor that can help you with investments, but who also has a good handle on the tax implications of your actions (and non-actions). Sign up to learn more about financial and tax topics.

Here is a video I did on this topic if you want to learn more.

originally published 11/12/2020

Linda Rogers, CFP®, EA, MSBA is the owner and founder of Planning Within Reach, LLC (PWR). Originally from New Jersey, Linda services clients throughout San Diego county and nationwide. She leads the design of PWR's investment portfolios which utilize broad, low-cost investments that integrate environmentally, socially, and governance (ESG) factors.

Planning Within Reach, LLC (PWR) is a fee-only and fiduciary wealth management firm offering one-time comprehensive financial planning, ongoing impact-focused investment management and tax preparation services in San Diego and nationwide. PWR is a woman-owned firm that specializes in busy professionals and impact investors. Planning Within Reach, LLC and their advisors do not receive commissions and do not hold any insurance licenses or brokerage relationships.