NEW YORK — Ah, late October, when the holiday season is on the horizon. Hot cider. Dropping temperatures. And taxes?
April 15 is still a ways away, but it’s not too early to start thinking about taxes for 2013. A confluence of factors means that many mutual fund investors could face bigger tax bills.
They can thank capital gains distributions. These payments made to mutual-fund shareholders are the result of the buying and selling that funds do throughout the year. Managers tally up all the gains booked from selling stocks and bonds, subtract whatever losses they incurred through sales and then pass along the remainder to their shareholders.
These distributions are made to investors’ accounts even if they haven’t sold any shares of the fund themselves, and the payments typically arrive near the end of each year. Investors must pay taxes on these distributions if the funds are held in a taxable account. If the fund is in a 401(k) or other tax-deferred account, investors don’t need to worry until they’re withdrawing from the accounts.
Rising with the market: Now that the Standard & Poor’s 500 index is trading at a record high, it’s likely that many stock funds are sitting on potential gains. The S&P 500 has jumped nearly 23 percent this year. If it climbs just a bit more, reaching a total gain of more than 23.5 percent, it will be the best year for the index in a decade. And the amount of capital gains that mutual funds distribute has tended to rise and fall with the tide of the stock market.
In 2007, when the S&P 500 hit a then-record high ahead of the Great Recession, the mutual fund industry paid $413.7 billion in total long-term capital gains, according to the Investment Company Institute. The next year, the financial crisis struck, and the index plummeted 38.5 percent. Funds distributed just $132.4 billion in 2008, a drop of roughly two thirds. Then in 2009, when the stock market hit bottom, mutual funds paid out $15.3 billion, the lowest amount since 2003, which was the year after stocks bottomed in the dot-com bust.
Capital gains distributions have since been on the upswing, rising three straight years to $99.4 billion in 2012. The S&P 500 has surged more than 150 percent since its low on March 9, 2009, propelled by earnings growth for companies and several rounds of stimulus by the Federal Reserve.
Rising tax rates: Tax rates on those capital gains distributions, meanwhile, are also rising for many high income earners this year. Married couples filing their taxes jointly, and with taxable income of more than $250,000, will see a new 3.8 percent surtax on taxable investment income. It’s to help pay for the federal government’s overhaul of the health care industry. Single filers who make more than $200,000 will also have to pay the surtax.
That means a tax rate of at least 18.8 percent on long-term capital gains for those fortunate enough to bring home that much. Last year, the top rate was 15 percent. The very top earners will see an even bigger jump in tax rates, a result of Congress’ compromise early this year over the “fiscal cliff.”
Married couples who earn more than a combined $450,000 will pay a tax rate of 23.8 percent on their long-term capital gains, including the 3.8 percent surtax. Single taxpayers earning more than $400,000 will also pay 23.8 percent on their long-term gains distributions.
Many fund managers say they also feel the pain of taxes due to capital gains distributions but call them the inevitable result of a winning investment.
“I’m a shareholder, so I get those gains statements also,” says Matt Fahey, who invests in and helps run the BMO Small-Cap Value and Mid-Cap Value mutual funds. “But it’s better than the alternative: losses.”
Reducing the bill: Investors can take some steps to minimize tax bills for funds held in taxable accounts. When considering costs, many investors start and end with a fund’s expense ratio, which shows how much it pays for annual operating costs. But investors can also consider a fund’s turnover, says Todd Rosenbluth, director of mutual fund and ETF research for S&P Capital IQ.
This number shows how quickly a fund turns over its portfolio due to purchases and sales. A higher turnover means that the fund’s manager is replacing investments quickly and buying and selling often. A lower ratio indicates that a fund is buying and holding.
Funds with lower turnover can mean lower tax bills because of their less frequent trading, but investors should keep in mind that a fund’s turnover can change significantly after new managers take over, Rosenbluth says.
Index mutual funds and exchange-traded funds tend to have low turnover. Some funds also make it one of their explicit goals to minimize gains distributions for investors. These are called tax-managed or tax-efficient funds.