THE HIDDEN TAX BOMB INSIDE YOUR MUTUAL FUND INVESTMENT
Mutual funds have been available to US investors for over 100 years.i Since the first offering of the Massachusetts Investors Trust (MITTX) opened on March 21, 1924, investors have used mutual funds to invest in the stock, bond, and commodity markets to grow their wealth. Mutual funds allow investors to pool their money with others to invest smaller sums and to achieve greater diversification. This flexibility has allowed millions of Americans to become investors and to significantly grow their wealth.
The Capital Gains Distribution: The "Tax Bomb" Hidden Inside Mutual Funds
While most are familiar with capital gains—selling an asset at a price higher than it was acquired—many aren’t familiar with the Capital Gains Distribution (CGD). Capital Gains Distributions occur when the fund manager sells assets inside the fund at a gain. Those gains are distributed to the fund shareholders, generally at the end of the year, who then must pay capital gains taxes at the long-term capital gains tax rate.ii
Is Your Neighbor Creating a Higher Tax Bill for You?
Keep in mind, Capital Gains Distributions are NOT caused by YOUR investment actions! You can be a buy-and-hold investor in a mutual fund and will still receive Capital Gains Distributions if they are distributed! So why would there be Capital Gains Distributions?
One reason might be an asset change directed by the fund manager—the fund manager sells security X to buy security Y. But another reason could be because the fund manager must raise cash to meet investor withdrawal demands.
Suppose you and your neighbor both own shares of the XYZ fund.iii When your neighbor sells shares, the fund manager must ensure cash is available to meet the demand. If cash is not available, the manager must sell a security in the fund to raise the necessary cash. This sale can trigger a capital gain for the fund which must then be distributed to fund shareholders (you). You haven’t sold your shares, yet you still receive a Capital Gains Distribution because of the actions of your neighbor!
Bear Markets Can Make Them Even Worse!
There is a myriad of reasons why investors regularly sell their mutual fund shares during the course of a year. But during periods of market volatility, selling pressure can increase as investors sell their stock mutual funds. These sales can trigger capital gains distributions for those fund investors who don’t sell. Buy-and-hold investors get hit with the double whammy: they ride the stock market down AND they must pay capital gains taxes, even when they took no action themselves!
Automatic Re-Investments Can Create Bigger Problems over Time
Over 95% of Capital Gains Distributions are reinvested by fund shareholders.iv Thus each year, with no sales and no new fund purchases, an investor’s exposure to larger capital gains distributions grows. Consider the following example: an investor buys 1,000 shares of XYZ fund at the beginning of the year at $10.00 per share. Near the end of the year XYZ has appreciated 5% and is priced at $10.50 per share and $1.00 per share ($1,000 total) is distributed as a Capital Gains Distribution.
The initial $10,000 investment has grown to a value of $10,500. At the time of the distribution, the share price is adjusted down $1.00 per share to $9.50 per share and $1.00 is paid to the investor. The total value of the investment remains unchanged at $10,500 ($9,500 XYZ + $1,000 cash). Because the investor has selected to have Capital Gains Distributions automatically reinvested, the $1,000 is cash is immediately used to purchase $1,000/$9.50 = 105.2632 new shares of XYZ fund.
The following year, the fund grows 5% again from $9.50 per share to $9.98 per share and again distributes $1.00 per share as a Capital Gains Distribution. The same mechanism applies: The share price drops from $9.98 to $8.98 per share and 1,105.26 * $1.00 = $1,105.26 is reported as a Capital Gains Distribution. Once reinvested, $1,105.26/$8.98 = 123.0802 new shares are purchased and the investor now holds 1,228.3434 shares of XYZ fund.
Each year, the total value of the investment has increased 5%. But the number of shares owned has increased and thus the potential for increasingly higher Capital Gains Distributions and with them a greater potential tax burden, too!
Investors often don’t notice this interaction as the total value of the investment simply reflects the growth of 5% per year. The initial investment of $1,000 is now valued at $11,030.52. But the investor doesn’t own 1,000 shares at $11.03 per share, but instead owns 1,228.34 shares at $8.98 per share—the same value but a different number of shares!v
Capital Gains Distributions Can Impact Medicare Premiums
Medicare premiums are based upon Modified Adjusted Gross Income (MAGI) from 2 years prior. Capital Gains Distributions are included in MAGI and can therefore impact your Medicare premiums! Don’t get caught paying a higher premium because your mutual fund investments pushed your family into a higher Income Related Monthly Adjustment Amount (IRMAA) bracket!vi
ETFs and Individual Securities Can Help diffuse the tax bomb
WealthBridge Capital Management utilizes Exchange Traded Funds (ETFs) and individual securities to help manage and diffuse the mutual fund “tax bomb”. By holding tax-efficient ETFs, municipal bonds, and other individual securities, investors can better manage capital gains taxes AND income taxes as THEY control the timing and type of taxes they pay, NOT other investors!vii
WealthBridge Capital Management is ready to help you update your plan. If you don’t have a retirement income plan, or your need to update or review your current plan, please reach out to us at 614-591-4515 or email us at info@wealthbridgecm.com to schedule an appointment.
i www.mutualfunds.com/eductaton/mutual-funds-brief-history
ii https://www.irs.gov/faqs/capital-gains-losses-and-sale-of-home/mutual-funds-costs-distributions-etc/mutual-funds-costs-distributions-etc-4
iii XYZ fund is a fictional fund used for discussion purposes.
iv Since 2010 as calculated from data in Table 30: Long-Term Mutual Funds: Paid & Reinvested Capital Gains by Type of Fund, Investment Company Fact Book 2024
v A slight difference may be seen due to rounding to 2 decimal places.
vi WealthBridge Capital Management does not offer tax advice. Please consult your tax professional for information specific to your situation.
vii https://www.morningstar.com/funds/etfs-vs-mutual-funds-benefits-that-really-matter