Kathleen Pender for SF Gate/Morning Star writes: Capital gains distributions made a comeback last year, which might surprise some mutual fund investors when they file their 2013 taxes.
Thanks to last year's soaring stock market, almost 58 percent of stock funds paid a distribution last year, up from 36 percent in 2012. Among funds that made distributions, the average one amounted to 6.1 percent of its year-end share price, up from 3.7 percent the previous year, according to Morningstar.
Among the 50 largest stock funds, the one making the largest distribution was Fidelity Adviser New Insights A, which distributed about 12 percent, Morningstar says.
Investors who own funds in a taxable account (outside an individual retirement account or 401(k)-type plan), must pay tax on their distributions each year, even if they are reinvesting them in more shares.
Capital gains are nice in the sense that they usually mean the fund is making money, but most shareholders would rather defer taxes as long as possible. Stock funds make most of their distributions near the end of the year, which also makes it hard to plan for them.
Shareholders who are reinvesting distributions might not notice them until they get a Form 1099-DIV from their fund company in January, or until they do their taxes. Those receiving large distributions they didn't prepare for could end up owing tax they didn't anticipate.
Reader Jerry Lang was caught off guard by distributions "that were several thousand dollars higher than in past years due to growth in the stock market," he says. His biggest ones came from Ivy Small Cap Growth, which distributed about 9 percent of its share price. Ivy Small Cap Value threw off 13 percent. "Previously the capital gains were in the 2 percent range," he says.
Lang worries that if his funds make similar distributions this year, he could lose the tax credit he is getting for health insurance premiums through Covered California.
Subsidy limit
If a distribution pushes his income above 400 percent of the poverty level, he would be ineligible for the credit and have to repay it when he files his 2014 taxes. He could sell the funds before they distribute gains, but that also could result in a taxable gain that would push him over the subsidy limit.
Gains received in 2013 won't affect the 2014 credit because it will be based on 2014 income. Gains on funds held in a retirement account won't affect health care subsidies because as long as the money is held in the account, it won't be added to adjusted gross income.
But this highlights one of the tax complications that come with mutual funds.
"When you own a mutual fund, you are paying taxes in two different ways," says Patrick Geddes, chief investment officer with Aperio Group. When you sell fund shares at a profit, you will owe tax on the gain the same way you would when you sell individual stocks. If you have a loss, you can use it to offset gains elsewhere in your portfolio. This you can control.
The other tax results from trading activity within the fund. This "is out of your control," Geddes says.
Each year, mutual funds must pay out almost all of their realized net capital gains, meaning gains on assets they have sold minus losses on assets they have sold.
If their losses for the year exceed their gains, they cannot distribute net losses to shareholders, but they can carry them forward to offset gains in future years.
After the 2008 stock market crash, many funds had so many losses to carry forward they did not have to pay out gains for several years, but "most of the losses from the 2008-09 debacle have been worked off," says Dan Wiener, chief executive officer of Adviser Investments.
Transfer of gains
When a fund pays out gains, its share price immediately drops by the amount of the distribution. The fund is simply transferring the gain from its portfolio to you.
If you are reinvesting distributions, you will add them to your total cost basis. That way you won't have to pay taxes on the same gains twice when you eventually sell your shares.
Funds report distributions on 1099-DIV forms in the following way: Short-term gains, which are taxed as ordinary income, appear in Box 1a, along with ordinary dividends. Long-term gains, which are taxed at a lower rate (up to 20 percent, depending on income), appear in Box 2a.
Funds that trade actively tend to have higher distributions than index and other tax-efficient funds with low portfolio turnover.
A fund can have an abnormally high distribution if a new manager comes in and revamps the portfolio or a large shareholder wants out and the fund has to sell stock to pay the shareholder off, says Russ Kinnel, Morningstar's director of fund research.
Investors can minimize the impact of capital gains distributions by holding index and other tax-efficient funds in their taxable accounts and high-turnover funds in tax-deferred retirement accounts.
At Morningstar.com, investors can look up a fund and gauge its tax efficiency by clicking on the tax tab. For each time period, it shows the fund's pretax return and the tax-adjusted return, which is what an investor in the top tax bracket would have earned after paying taxes on distributions. The percentage rank in category show how tax-efficient it is compared to similar funds. The lower this number, the more tax-efficient the fund is. A fund ranked 10 is in the top 10 percent of similar funds.
Capital comeback
Capital gains distributions by stock funds:
| Stock funds that paid distributions | Average distribution* | |
| 2011 | 29.3% | 4.6% |
| 2012 | 36.4 | 3.7 |
| 2013 | 57.8 | 6.1 |
*Of funds that made distributions, this shows the average distribution as a percent of the fund's year-end share price (with distributions added back to year-end share price).
