This year looks to be a record year for capital gain distribution
An investor selling a stock for a higher price than the purchase price is called a capital gain (in simpler terms it is called a profit, but we’re going to use technical terms for a moment). To give an example, if you bought Amazon stock at the price of $2,000 in July of 2019 then sold it at the price of $3,000 in November of 2020, then the capital gain would be $1,000.
Although a little more complicated, mutual funds operate in the same capacity. If a mutual fund sells a stock for a profit then it too receives a capital gain. By law, it is required to pay the majority of the gain to the shareholders in the way of distributions. This is after deducting the fund’s operating expenses, of course.
Short and Long-Term Capital Gains
Mutual funds have two types of capital gains: short-term and long-term
If the mutual fund itself, not the fund investor, has held the stock for over a year then the profit from the sale of the stock is treated as a long-term capital gain. This is subject to a tax rate of a maximum of 20% for shareholders. If the fund has held the stock for less than a year, the profits from the sale of the stock are treated as a short-term capital gain. It is then taxed at the investor of the fund’s regular income tax rate.
Estimates are Out
The fall season is when mutual fund firms usually begin estimating and publishing their capital gain, and they then make final distributions before the year ends. It should be known that mutual funds are required to make distributions before December 31st meaning they don’t all make distributions on the same day. Mutual funds report whether the distributions are short or long-term on the IRS Form 1099-Div after the end of the year. This is done to help shareholders keep track of the type of capital gain it is.
Given this information, investors should be aware of the term ‘buying the dividend.’ This is when an investor purchases shares of a mutual fund just before the fund makes distributions. An investor should avoid ‘buying the dividend’ if they are planning to make a large lump-sum investment in a mutual fund.
Lastly, it is important to note the four different types of distributions from a mutual fund and the tax implications for investors: capital gains, ordinary income (ordinary dividends), qualified dividend, and finally non-dividend distributions (these are often called a return of capital). With this, it is important to talk with your financial advisor about the implications of mutual fund investing and taxes.
What will 2020 Bring?
It is estimated that investors are likely to see a record year for taxable distributions tied to capital gains. Of course, we cannot be certain how much will be distributed this year, but history can provide us with an idea. Data from the Investment Company Institue (ICI) shows that mutual funds paid out capital gains totaling $511 billion in 2018 and $355 billion in 2019.
The gains in 2018 were much greater than those in 2019, but why? It is in part due to the volatility seen by investors in 2018, and that there was a lot of selling pressure on mutual funds, especially at the year’s end. In 2018 the S&P 500 ended down 4.38%. During October and December of that year, the S&P 500 lost 6.84% and 9.03%, respectively. The declines resulted in the aforementioned selling pressure. In addition, in 2020 investors have dramatically moved out of equity mutual funds to money market funds which have placed selling pressure on equity mutual funds (they need to sell in order to make redemptions, thus triggering gains).
According to the ICI, from January 2020 to September 2020 investors have:
- Moved $446 billion out of equity funds
- Moved $761 billion into money market funds
This is around double the numbers from the same time period in 2019 when investors moved $220 billion from equity funds and moved $370 billion to money market funds.
What Should You Do?
There are many things that can be done do to position a portfolio properly amidst what is shaping out to be a record-making year for capital gain distributions. The first is to simply be aware of the estimates provided by mutual fund companies, along with considering different strategies like ‘harvesting losses.’ The financial professionals at NEST can help you determine the impact this year could have and design a course of action that is consistent with your overall financial plan.