Mutual Fund Holders Face Double Trouble

If you’re a stock-mutual fund holder, you may face a double whammy this year.

First, the value of your holding has likely dropped along with the overall market. 

As shareholders have exited mutual funds amid the market’s slide, managers have been forced to sell shares to cash these investors out. 

That's where the second whammy comes from.  

It's because those sales often generate capital gains on longterm holdings which generate capital gains distributions to shareholders, who then have to pay capital gains taxes on them.

Christine Benz, Morningstar’s director of personal finance, discussed how investors can deal with the capital gains issue.

One option is to sell the fund before the capital gains distributions. But remember that when you sell you fund shares, if they’re trading higher than when you bought them, you will owe capital gains tax on that appreciation.

Silver Lining

One silver lining from the market’s decline this year is that it would likely limit the amount of your capital gain if you indeed sell your shares.

Also, “many of the funds making distributions this year have been serial distributors,” Benz said. “This isn't the first year they've made distributions. If you've been reinvesting those distributions, you're able to increase your cost basis by the amount of that distribution.”

So that would lower your capital gain.

Of course, if you really like your fund, it might be worth it to just pay the capital gains tax on the distribution and hang in there with the fund.

“And remember you are getting credit for these distributions, even though you're having to pay taxes in the current year in which you receive the distribution,” Benz said.

“If you're reinvesting back into the fund, you're increasing your cost basis. That reduces the taxes that will be due down the line.”

Stick to Fundamentals

You’re better off making your decision of whether to keep your fund based on investing fundamentals, rather than tax factors, Benz noted.

Another possibility for investors is to sell a fund, but purchase a similar one if they want to retain their exposure to the sold fund’s strategy.

In that case, “you need to be aware of what's called the wash sale rule, which means that if you purchase something that the IRS considers substantially identical to the thing that you've just sold, and you do that within 30 days of the sale, you disallow the tax loss,” Benz said.

“That means that if you're swapping out of an index fund and into an exchange-traded fund that tracks the same market benchmark, it’s probably not a great idea from the standpoint of the wash sale rule.”

But, it’s ok to exit an actively-managed fund and then dive into a passively-managed one, Benz said.