Mutual fund investors brace for hefty capital gains taxes

It's that time of year again when clocks are set back an hour, the leaves start to fall, and mutual funds ramp up to distribute those pesky capital gains.

This year, the message is another reminder of the relative tax inefficiency of actively managed mutual funds, especially compared to exchange-traded funds.

As asset management companies start posting the capital gains that will be distributed to fund shareholders over the next several weeks, the good news of strong investment performance is once again being diluted by some hefty capital gains that come from normal portfolio turnover.

“Year to year, the broad theme is the same, but we are seeing some significant payouts, largely from equity growth mutual funds,” said Christopher Franz, associate director of equity strategies at Morningstar.

While the average U.S. equity mutual fund has gained more than 21% this year, the portfolio turnover that can be amplified by management changes and redemptions has pushed many funds’ capital gains distributions even higher into the double digits this year.

According to CapGainsValet, there are at least 20 mutual funds distributing capital gains of 30% or more, and more than 85 funds distributing gains of between 20% and 29%.

Examples of funds distributing capital gains of more than 30% include the $436 million DFA Enhanced US Large Company (DFELX), up 25.7% this year, the $643 million Goldman Sachs Small Cap Growth Insights (GCSSX), up 30.6%, and the $756 million Thornburg Small/Mid Cap Growth (TCGRX), up 6.8%.

Some of the funds logging distributions of more than 20% include the $2.8 billion American Century Equity Growth (AEYRX), which was up 26% this year, the $14.9 million Fidelity Flex Small Cap (FCUTX), up 37.2%, and the $9.8 billion T. Rowe Price Science and Technology (TSNIX), up 13.7%.

“Strong markets recovering from 2020 and seeing continued gains in 2021 have set up an environment for high capital gains distributions to likely occur, because actively managed funds are sitting on a lot of winning positions,” said Todd Rosenbluth, director of mutual fund and ETF research at CFRA.

For investors and financial advisers, annual capital gains distributions continue to be an unfortunate reality of mutual fund investing. Even if a mutual fund generates an investment loss, the Internal Revenue Service requires funds to distribute 98% of their calendar year income to shareholders, which can mean a tax hit.

And even though fund companies give shareholders plenty of notice, selling out of a fund before the taxable distribution usually doesn’t make sense because it would trigger another taxable event from the fund’s investment performance, assuming it was positive.

Rosenbluth cited the painful reality of capital gains taxes for mutual funds held outside of qualified retirement accounts as one of the reasons major fund companies have been converting mutual funds into ETFs.

“When ETFs perform well, as long as investors stay loyal to their ETF, they’re extremely unlikely to experience any capital gains because the ETF creation and redemption process washes away capital gains,” he said. “When someone sells their ETF, it doesn’t impact other ETF investors the way it does in a mutual fund.”