Capital Gains for the 2020 Season Could be Huge
A Record Year for Capital Gain Distributions?
This year is shaping up to be a record-breaking one for capital gain distributions. For investors, understanding how capital gains work is essential—especially when it comes to mutual funds.
At its simplest, a capital gain occurs when you sell an asset for more than you paid. For example, if you bought Amazon stock for $2,000 in July 2019 and sold it for $3,000 in November 2020, your capital gain would be $1,000.
Mutual funds operate in a similar way. When a mutual fund sells stock for a profit, it realizes a capital gain. By law, most of these gains must be distributed to shareholders—after the fund deducts its operating expenses.
Short-Term and Long-Term Capital Gains
Mutual funds make two types of capital gain distributions:
Long-term capital gains apply when the mutual fund has held a stock for more than one year before selling. These gains are typically taxed at a maximum 20% rate.
Short-term capital gains occur when a stock is held for less than one year. These are taxed as ordinary income at the investor’s personal tax rate.
Capital Gain Estimates Are Out
In the fall, mutual fund companies generally begin estimating and publishing their projected capital gain distributions, which are finalized before the end of the year. By law, funds must make these distributions before December 31, but they do not all pay out on the same day.
Shareholders will receive an IRS Form 1099-DIV after year-end that details whether distributions were short-term or long-term, which helps clarify tax obligations.
One important note: investors should avoid "buying the dividend." This happens when someone purchases mutual fund shares just before a distribution is made. Doing so can result in an immediate taxable event, potentially reducing the value of the investment.
Types of Distributions and Their Tax Implications
Mutual funds typically make four types of distributions, each with different tax considerations:
Capital gains
Ordinary income (ordinary dividends)
Qualified dividends
Non-dividend distributions (often called a return of capital)
It's wise to discuss these potential tax implications with your financial advisor, particularly if you’re planning a large investment in mutual funds.
What Will 2020 Bring?
It’s estimated that 2020 could see record taxable distributions from capital gains. While the exact figures are yet to be determined, historical data gives us some perspective:
According to the Investment Company Institute (ICI):
2018: Mutual funds paid out $511 billion in capital gains.
2019: They paid out $355 billion.
The larger payouts in 2018 were due to high market volatility and selling pressure on mutual funds. The S&P 500 ended 2018 down 4.38%, with losses of 6.84% in October and 9.03% in December. The resulting redemptions forced funds to sell assets, triggering capital gains.
A similar trend appears to be playing out in 2020. From January through September, according to the ICI:
Investors pulled $446 billion out of equity mutual funds.
Investors moved $761 billion into money market funds.
By comparison, during the same period in 2019, outflows from equity funds were $220 billion, and inflows to money markets were $370 billion.
What Should You Do?
With such significant capital gain distributions likely, investors should take proactive steps, including:
Staying informed about mutual fund distribution estimates.
Considering strategies like tax-loss harvesting to offset gains.
Evaluating the timing of new investments to avoid unintended tax consequences.
At NEST Financial, we help investors navigate these complex decisions. Our team can assess your unique situation, help you understand the potential impact of capital gain distributions, and develop a strategy consistent with your overall financial plan.