As tax season approaches and people start gathering their important tax documents, there’s one specific surprise we anticipate some investors may face–one we actively work to avoid.
One of the biggest surprises we expect to see in 1099 tax reporting comes from capital gain distributions–specifically those who hold mutual funds. To pull back the curtain, this occurs at the mutual fund or ETF level when fund managers or traders decide to sell certain securities within the fund. This isn’t the investors selling the fund themselves; rather, it’s the fund managers making trades.
These capital gains, realized at the fund level, are then passed down to investors in proportion to their ownership.
So, hypothetically, you could be an investor who didn’t make a single stock sale all year, yet still receive a hefty capital gain tax bill. You might wonder, “What the heck? I didn’t do anything!”
Unfortunately, there’s not much you can do retroactively except for having the foresight to work with a financial team that proactively monitors capital gain distributions throughout the tax year.
It might be rightly seen as a downside to owning mutual funds, especially in a year when the value of the fund declines. Imagine starting the year with a $100,000 investment, ending with an $80,000 balance, and still getting hit with a $10,000 capital gain distribution. That’s really adding insult to injury.
In down markets, many fund managers choose to sell securities that have performed well, rather than selling underperforming ones. Instead of offloading the losing stocks, they sell winners like Microsoft or Apple, which have large, embedded capital gains at the fund level. That way, they avoid selling the underperforming assets, which could further hurt the fund’s overall performance.
As a result, investors can face a double whammy—experiencing a decline in their fund’s value while still being on the hook for a taxable capital gain distribution.
