Quizmaster, Doug Hutchinson, presents his quiz for the month. Here, Doug explores how to manage capital gains tax on mutual funds.
Consider this Scenario:
Your friend Joe is preparing his tax returns and is confused as to why he owes taxes on a mutual fund position that he hasn’t sold and went down in value from the purchase price.
"I bought $100,000 worth of a mutual fund on October 1st at $10.00 per share in a taxable brokerage account. On December 1st I received a capital gains distribution from the mutual fund. At the end of the year the mutual fund was worth $9.90 per share."
"I didn't sell any shares of the mutual fund after I bought them and the price per share has gone down in value since I bought the mutual fund. Why would I owe taxes in this scenario?"
What is a potential reason why Joe would owe taxes in this scenario?
Solution:
A mutual fund realizes a capital gain when it sells an investment in the fund for more than its purchase price. Even though Joe didn't sell any of his shares of the mutual fund, he still owes taxes for the net capital gains of the underlying holdings of the fund. These net capital gains are distributed to all shareholders of the mutual fund who own the fund on a certain date (this is the distribution that occurred on December 1st in Joe's case).
Even though Joe didn't sell any of his mutual fund shares, he did receive a capital gains distribution from the mutual fund. This distribution is a taxable event for Joe since he owns the mutual fund in a taxable account.
It is possible that these capital gains occurred in the fund earlier in the year before Joe even bought the fund. Joe still owes taxes on these gains because he owned the fund when the distribution was paid.
Note that Joe owes taxes for this distribution regardless of whether the market value of the mutual fund shares is higher or lower than his purchase price of those mutual fund shares.
If this mutual fund regularly makes significant capital gains distributions, Joe could consider holding the fund in a tax deferred account such as an IRA.
He could also consider a managed account solution where he would own the underlying holdings of a strategy but he has his own cost basis of each position that is unique to his account. He could also potentially take advantage of loss harvesting opportunities in a managed account where he could seek to offset realized gains with realized losses in his account and potentially not owe any capital gains taxes at all.
Joe should consider consulting a financial planning and/or tax professional to help him meet his unique financial goals.
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This quiz is intended for informational and illustrative purposes only. This material is not intended to be relied on as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The information presented is general information that does not take into account your individual circumstances, financial situation or needs, nor does it present a personalized recommendation to you. The information and opinions contained in this material are derived from sources deemed reliable, are not all-inclusive and are not guaranteed as to accuracy.
