Mutual funds are preparing to issue 2023 capital gains distributions – and that could mean a tax surprise is lurking in your portfolio. Fund families are issuing estimated capital gains distributions, which they will make to their shareholders in December. Though it’s been a tumultuous year, with the S & P 500 up more than 8% in 2023 yet on pace for a third consecutive month of declines, investors in some funds could see some sizeable distributions. Consider that the Columbia Real Estate Equity Fund (CREEX) is on pace for an estimated distribution of ranging from 24.5% to 29% of its net asset value. Shareholders who keep these funds in a tax-deferred account, like an individual retirement account or a 401(k) plan, aren’t subject to taxes on these distributed gains. However, those who hold the funds in taxable brokerage accounts could be on the hook for levies on these sums. The Internal Revenue Service deems these capital gains to be long term, meaning they’re subject to rates of 0%, 15% or 20%, based on your taxable income and filing status. Your brokerage will likely send along a Form 1099, reflecting these distributions, and you’ll need this form to prepare your 2023 taxes. Drivers of capital gains You don’t have to sell shares of your fund to get hit with these distributions and their taxes in a given year. “The biggest driver, as I look at the larger estimated distributions, seems to be a story about flows,” said Stephen Welch, senior manager research analyst at Morningstar Research. For starters, sharp outflows from a fund require the fund manager to sell holdings in order to cash out departing investors. As managers sell off appreciated positions, the capital gains are passed on to the remaining shareholders. “Excluding 2022, we’ve had 10+ years of strong stock market performance, and funds are sitting on embedded gains,” said Welch. Portfolios that are actively managed can also generate big capital gains if there’s a lot of turnover. If the manager dumps holdings that have seen a lot of appreciation but there aren’t enough realized losses to offset the gains, then they too are distributed to shareholders. Planning going forward As tempting as it may be to dump a mutual fund that’s had a big distribution, investors should pause: If you’ve had a lot of appreciation since you’ve been a shareholder, you could wind up levied on realized gains when you sell. However, if you like the fund’s strategy, it may be worth seeing whether there’s a cheaper tax-efficient exchange traded fund that you can use instead, said Welch. Investors should also pay attention to their cost basis – that is, your investment into the fund. “If you reinvest the dividend into the fund, your cost basis increases, and you’ll have less embedded capital gain,” he said. With the year winding down, it might also be a good idea to talk to your financial advisor and your accountant to see whether there are realized losses within your portfolio to help offset the capital gains distribution. Dumping your losing positions and using the losses to reduce the tax impact from gains is known as tax-loss harvesting. Consider it a move toward your year-end portfolio prep. “I would say there’s no reason to necessarily panic about a huge distribution,” said Welch. “It’s not the end of the world to have one.”
