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This year, in a down market, you could wind up owing tax on putative appreciation. Here’s what to do about that.
A whipsaw for investors in the Columbia Integrated Large Cap Growth Fund: They’ve been slaughtered this year, down 22% so far, and now they are going to owe tax on a huge dollop of supposed capital appreciation amounting to 40% of their accounts.
These miserable folk have plenty of company. The combination of a bear market, an exodus from actively managed funds and the peculiarities of fund distributions means that, even in a money-losing year, an investor can owe the IRS a wad of tax on long-term gains.
Morningstar recently highlighted the problem with a tabulation of funds expecting to make fat capital appreciation payouts for 2022. Its list of offenders covers scores of funds from name-brand vendors like American Century, Fidelity, Franklin Templeton and T. Rowe Price.
Here, I’ll explain three things:
—How does the whipsaw tax happen?
—What defensive maneuvers can you use?
—What can you do to prevent future damage from the whipsaw?
The phenomenon affects only taxable accounts. If all of your fund money is in tax-favored accounts like IRAs, you can skip to the last paragraph of this story.
1. How does the whipsaw tax happen?
There is at least some rationality in how the tax code treats funds. Starting principle: The fund pays no tax of its own, so any gains it realizes from stock appreciation ought to flow through to the fund shareholders, and they ought to put those gains on their tax returns.
Example A: You buy a fund share for $20. All of the stocks in its portfolio double, so now your fund share is worth $40. The portfolio manager sells off some of the winners, enough to generate a long-term gain of $4 per fund share. The tax code dictates that this $4 be paid out to you by the end of the year. At that point your fund share shrinks in value to $36, you have $4 in cash and you owe tax on the $4.
The tax bill is unpleasant, but you can’t complain. You’re in the same situation as if you had bought the same stocks yourself and then sold off a few.
Important point: It doesn’t matter whether you reinvest the $4 in the fund. You owe the same tax.
Example B: Same fund purchase at $20, same doubling to $40, but then the bear market arrives and the fund value drops to $30. Again, the manager lightens up some positions and realizes gains equal to $4 per fund share. The gains are paid out. Your fund share shrinks in value to $26 and you have $4 in cash and also a tax bill.
Unfair? Not really. You owe tax at the end of a bad year, but you are still ahead on the fund share and you also have that cash.
Example C: You get in late, buying the fund share for $40. The fund crashes in price to $30. The manager sells some winning positions acquired long before you arrived. The gains are distributed to all shareholders equally. So you wind up with a tax bill, even though you are underwater.
This is when you are motivated to write your congressman.
It gets worse. Suppose that half the fund shareholders depart before the distribution takes place. They get $30 a share in cash and have no long-term gain distribution to put on their tax return. It doesn’t matter to them. The ones who bought in at $20 have a $10 profit and declare that on Schedule D. The ones who bought at $40 have a $10 capital loss and declare that.
But if you stick around, you suffer. The tax code says that all of the fund’s realized gain has to go out. None of it is assigned to the departing customers. So all of it lands on the shoulders of the surviving fund clients. With half the shareholder base gone, the survivors wind up with distributions of not $4 a share, but $8. If you bought in at $40 you are left with a fund share worth only $22, plus $8 in cash, plus a nasty tax bill.
You probably can’t blame the portfolio manager for this. He may have been selling appreciated stocks not to buy new stocks but to raise cash to pay off the departing customers. Mark Wilson, who tracks unwelcome distributions at CapGainsValet.com, points out that much of the tax damage taking place this year is occasioned by redemptions.
Note: I’m keeping the math in Example C simple by assuming that all remaining shareholders reinvest all of their payouts. If they don’t, the damage would be worse than $8.
#2. What defensive maneuvers can you use?
In examples A and B, the correct response is to stand pat. Selling the fund would leave you worse off. You’d have to pay tax on both the gain distribution and a gain on the fund share.
In example C, though, it makes sense to get out. Your tax return would show an $8 distribution and a loss of $18 on the fund share (bought at $40, sold ex-dividend at $22). Net capital loss: $10.
Could you improve your lot by exiting just before the distribution? Nope. You’d have the same $10 loss (bought at $40, sold at $30).
What if you bought the lousy fund less than 12 months ago? That raises the interesting prospect of receiving $8 of long-term gain (the more desirable kind of gain) while booking an $18 short-term loss (the more desirable kind of loss).
That would be a nice arbitrage if you could get away with it, but you can’t. A tax code provision dictates that, in this example, the first $8 of your short-term loss on the fund share gets converted into a long-term loss. So, no matter whether you leave before or after the distribution, you end up with a $10 short-term loss.
Example D: You bought the fund at $21, saw it climb to $30, then got an unwanted $8 distribution. What’s best now?
If you exit, you’ll have $9 of capital appreciation on which to pay tax ($1 from selling the fund share, $8 from the gain distribution). If you stand pat, you’ll owe tax on only $8 of gain—but will face a future littered with more unwanted distributions. My advice: Bite the bullet. Sell the fund, paying a little extra tax now, then invest the proceeds in a different kind of stock fund that is not going to inflict distributions on you. That different kind of fund is described in Section #3 below.
To sum up: If your fund share, after the payout, is worth a lot more than what you paid for it, stay put in the fund. If it’s worth less than what you paid, or only a little bit more, depart. And it doesn’t matter whether you depart before or after the payout.
One last point, to answer the nitpickers who say it sometimes does matter whether you sell before or after a payout. If the fund has short-term gains, you’re better off selling before the payout. Example E: You bought the fund at $20 years ago, it’s now worth $21, and it’s about to dish out $1 of short-term gain. As it happens, short-term gains from an investment company show up on your tax return as ordinary income, akin to interest income. (Totally unfair; write your congressman.) In this case selling early means that the $1 will instead be taxed at the favorable long-term rate.
However, please note that short-term gain distributions in anything other than picayune amounts are quite uncommon. Short gains from mutual funds just aren’t worth losing sleep over.
#3. What can you do to prevent future damage from the whipsaw?
A common refrain among advisors is this: Don’t go into an equity mutual fund near the end of the year, because you could be buying a distribution that you don’t want.
I think this advice is too feeble. Here’s mine: Don’t buy an equity mutual fund for a taxable account at any time.
Instead, do what several trillion dollars of smart money has recently done, which is to invest in exchange-traded funds that track indexes like the S&P 500. Stock index funds organized as ETFs almost never make distributions of capital appreciation.
Sad truth: Active stock funds collectively underperform stock index funds. If you must try to beat the odds by owning an active stock fund, put it in your IRA.