Bailey Scarano Blog

Handle Mutual Funds With Care at Year End

As the year is coming to a close, it is a good time to review any mutual fund holdings in your taxable accounts and and do what is necessary to avoid potential tax traps.

Avoid surprises

Near the end of the year, mutual funds typically distribute all or most of their net realized capital gains to investors. Unlike stocks, you can’t avoid capital gains on mutual funds by simply holding on to your shares. If your mutual funds are held in taxable accounts, these gains are taxable regardless of whether you receive them in cash or reinvest them in the fund. 

For each fund, determine how large these distributions will be and get a breakdown of long-term vs. short-term gains. If the tax impact will be significant, consider strategies to offset the gain, such as selling other investments at a loss. 

Buyer beware

Avoid buying into a mutual fund shortly before it distributes capital gains and dividends for the year. There’s a common misconception that investing in a mutual fund just before the ex-dividend date (the date by which you must own shares to qualify for a distribution) is like getting free money. 

In reality, the value of your shares is immediately reduced by the amount of the distribution, so you’ll owe taxes on the gain without actually achieving an economic benefit.

Seller beware

If you plan to sell mutual fund shares that have appreciated in value, consider waiting until just after year end so you can defer the gain until 2021 — unless you think you’ll be subject to a higher rate next year. In that scenario, you’d likely be better off recognizing the gain and paying the tax this year.

When you do sell shares, remember if you bought them over time each block will have different holding periods and cost basis. To reduce your tax liability, it’s possible to select shares for sale that have higher cost bases and longer holding periods (known as the specific identification method), thereby minimizing your gain (or maximizing your loss) and avoiding higher-taxed short-term gains.

Think beyond taxes

Of course, investment decisions shouldn’t be driven by tax considerations alone, but they are an important factor. You also need to know your risk tolerance and consider your overall financial goals. Contact us to discuss your capital gains and other year-end strategies for minimizing the tax impact of your mutual fund holdings.