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Mutual Funds and Capital Gains: Could You Be Making a Costly Mistake?

If you’re thinking about buying mutual funds before the end of the year, consider this.

We’re currently several years into a bull market. Prior to the election, the market had had a broad rally since 2009. Then, Trump defied the odds. In the week following his surprising win, the markets responded to the President-elect’s pledge to dismantle Dodd-Frank and unleash economic growth. The Dow Jones Industrial average had its best week since 2011, and the S&P 500 saw its highest gains in three years.

All this is good news for investors. But bad news for mutual fund buyers who could soon find themselves hit with unrealized capital gains—and a sizable tax liability.

Beware the End-of-Year Capital Gains Tax

If you’re considering buying mutual funds for a retirement account, dividend and capital gains distributions are not an issue for you. But if you’re investing in mutual funds within a taxable account, you’ll want to do your due diligence. Most mutual funds will tell you the unrealized potential capital gains in the underlying mutual fund.

Here’s why it’s important to ask.

Suppose I’m a mutual fund manager, and I own one security—Apple common stock—in that mutual fund that I bought five years ago for $25. Today, it’s worth $100. If I sell my Apple common stock, everyone who owns my mutual fund at the end of the year will receive $75 in capital gains.

If you buy into my mutual fund today, you could have those capital gains distributed to you tomorrow. Meaning you’ll incur the cost of the gain without ever having reaped the benefits.

Plan Ahead, So You Can Avoid the Worst

Through prudent, proactive portfolio management, you can head off unrealized capital gains and associated tax losses by knowing the warning signs of impending distributions. You can also mitigate the cost of these unwanted capital gains; for example, you could sell your original shares at a tax loss and buy a like kind mutual fund the very same day.

Navigating capital gains season doesn’t have to be difficult. You just need to know what’s at stake, what questions to ask, and where to turn for answers and advice.

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