You may have to pay tax on a mutual fund, even if you didn’t sell any shares.

Transcript:

Hi, this is Linda Rogers from Planning Within Reach. Clients are sometimes confused at why they have to pay tax on capital gain distributions for a mutual fund when they didn't sell any shares.

The reason is that the mutual fund that you hold may still be buying and selling positions and they may have had redemptions. They have to pass those realized gains onto you - the shareholder.

Capital gain distributions are not a complete surprise.

Mutual fund companies will typically post their preliminary distributions in the fall and you can go ahead and evaluate if that information is helpful in terms of potentially selling the fund before the distribution comes. Even if you held the stock all year, if you sell before that distribution comes out, you do not have to pay tax on that phantom income. It doesn't mean that you should sell the fund before the distribution comes. It's just that if you are, perhaps, in a taxable portfolio of active funds and you are trying to transition to index funds that have less turnover and tend to be lower cost, it might just be the information that you need to decide which of your active mutual funds you are going to sell this year.

Let me go ahead and just show you quickly how to do an evaluation.

Okay. So this is the 1099-DIV and I just wanted to show you that because this is where you would see those total capital gain distributions. So this is not money that you generated from selling a position, but it is the capital gain distribution the fund will pay out. Here is an example of a year-end distribution report from Vanguard for 2019. So you can go ahead and look up which fund you have.

I will just do an example for Selected Value, so here it is. It tells me the approximate distribution - 6.06% of NAV - and the ex-div date is 12/17/2019. Then you can go ahead and look at your position. So let's just say you have 850K of Selected Value, your basis is 825K.

Option #1 - Hold the fund and receive your distribution, increase your basis.

What is the distribution amount that you're going to get? You are going to take that 6.06% that was in the report, put that in your spreadsheet, and it gives you an approximate value of what the distribution amount will be. If you do not want to get this distribution and you were going to sell out of the fund anyway, if you sell by the day before the ex-div date, so 12/16, you will avoid that distribution.

These capital gain distributions are taxed at long-term capital gain rates, regardless of how long you held the position.

Enter in the appropriate percentage for you and if you get hit by the Medicare surtax, you are going to take that into consideration as well.

Option #2: Sell the Fund.

Again, you don't want to just sell a fund to avoid a distribution. You need to look at the full picture. In this example, there would be a gain by selling the fund. That taxable gain would again be hit by either short or long-term capital gains rates, whatever is appropriate, and you'll pay tax on that sale. So now you have the information you need to be able to do an evaluation. In summary, your choices are to pay tax on the distribution when it comes out and increase your basis or to go ahead and sell and pay $6,000 on that gain.

If you are going to be selling - where are the proceeds going?

If the proceeds are going to be going into another fund, one that has an even bigger distribution, you want to take that into account. In this particular example, I have it going to an index fund that has lower turnover, is more tax-efficient, and actually has no planned distribution.

Make sure that you work with someone who understands the investment side of things as well as the tax side of things. Don't just sell out to avoid the distribution, but it may be helpful to know that these distributions aren't a complete surprise and it's something that you can incorporate into your planning. I am Linda Rogers from Planning Within Reach.

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.