by If you’re a mutual fund holder, you could face a double whammy this year.
First, the value of your holding has likely declined along with the overall market.
As shareholders exited mutual funds due to the market drop, managers were forced to sell shares to cash out these investors.
That’s where the second whammy comes from.
It’s because those sales often generate capital gains on long-term holdings that generate capital gains distributions to shareholders, who then have to pay capital gains taxes on them.
Christine Benz, director of personal finance at Morningstar, discussed how investors can approach the capital gains issue.
One option is to sell the fund before the distribution of capital gains. But remember that when you sell your fund shares, if they trade higher than when you bought them, you’ll pay capital gains tax on that appreciation.
Silver lining
One upside of the market’s decline this year is that it would likely limit the amount of your capital gain if you actually sold your stock.
Additionally, “many of the funds that have made distributions this year have been serial distributors,” Benz said. “This isn’t the first year they’ve been making deployments. If you reinvested those distributions, you are able to increase your cost base based on the amount of that distribution.
So that would reduce your capital gain.
Of course, if you really like your fund, it might be worth it just to pay capital gains tax on the distribution and stick there with the fund.
“And remember that you are receiving credit for these distributions, even if you owe taxes in the current year you receive the distribution,” Benz said.
“If you’re reinvesting back into the fund, you’re increasing your cost basis. This reduces the taxes that will be owed down the line.
Stick to the basics
You’d be better off deciding whether to keep your fund based on investment fundamentals, rather than tax factors, Benz noted.
Another possibility for investors is to sell a fund, but buy a similar one if they want to keep their exposure to the strategy of the fund being sold.
If so, “you must be aware of what’s called the wash sale rule, which means that if you buy something that the IRS considers to be essentially identical to the thing you just sold, and you do so within 30 days of the sale , you do not allow tax loss,” Benz said.
“That means that if you’re switching from an index fund to an exchange-traded fund that follows the same market benchmark, that’s probably not a great idea from a wash sale rule standpoint.”
But it’s okay to exit an actively managed fund and then dive into a passively managed one, Benz said.
