As the end of the year approaches, many mutual fund investors could be facing significant tax liabilities from their investments. Mutual funds are required by law to pay out realized capital gains to investors in the form of (typically annual) distributions. As usual, some funds are paying significant capital gain distributions to investors, many above 10% of fund assets.
It is important to note that this doesn’t mean the fund necessarily gained 10%+ this year, or that the individual investor owning the fund experienced such a gain. Actively managed mutual funds can frequently be very tax inefficient, pushing tax liabilities onto investors who did nothing on their own to realize a capital gain.
Morningstar has a list of funds paying capital gains over 10% of assets, and some significant names are there, including a few funds from Columbia and popular real estate funds from Third Avenue and JP Morgan. You can see Morningstar’s list here: http://www.morningstar.com/advisor/t/67923534/these-funds-are-set-to-make-hefty-taxable-distributions.htm
Let’s evaluate the impact of these distributions with a hypothetical client.
John Doe owns a $25,000 position in Mutual Fund XYZ, which just reported a 15% capital gain distribution for 2012.
John’s taxable distribution is $3,750, and his total investment is still worth $25,000.
In Colorado, John will pay 15% long-term capital gains and just under 5% Colorado state income taxes on the $3,750, for a total of about $750.
After his tax bill, John’s net investment is worth $24,250, a loss of 3% thanks to his tax liability.
Compared with someone in a more tax efficient investment, John starts off 2013 3% behind, a tough hurdle for an active manager to overcome.
This is a simple example of the long-term impact costs and taxes can have on an investor’s long term return, and how important it is for investors to stay focused on reducing expenses and tax liabilities when possible.
Bason Asset Management 