A Taxing Situation for some fund owners

[Chuckanut]

We seem to be at risk for paying capital gains tax while our funds have dropped in value. IIRC, this is not the first down market that has left coal in our stockings after a down year.

https://humbledollar.com/2022/12/a-taxing-situation/

Even in a down year for stocks and bonds, a mutual fund may realize capital gains, which are then passed on to shareholders. These could come as a nasty surprise to investors already smarting from 2022’s steep losses.

This year, many investors appear to have sold their actively managed funds. These sales force a fund’s manager to sell stocks to generate the cash needed to pay off departing shareholders. That creates a tax conundrum, because many funds hold stocks that enjoyed significant gains in 2020 and 2021. Selling these appreciated assets produces a capital gain. The fund can offset these gains by selling stocks at a loss. But as more people bail out of a fund, the manager may run out of losses to realize and instead must sell winners to generate cash.

 

[COcheesehead]

Cap gains are at 0% up to $83,350 for couples. Dividends are at 0% up to the same level.

 

[NW-Bound]

Cap gains are at 0% up to $83,350 for couples. Dividends are at 0% up to the same level.

And one should add standard deduction of $25,900 for a couple on top of that.

Immediately after retiring and having no earned income, I was selling equities every year to realize gains up to the limit of 0% tax on cap gain.

And I immediately bought back the same. This reset the basis on these stocks.

Until the end when I had to sell these stocks for real for living expenses (prior to 59-1/2), there was never any tax.

 

[audreyh1]

Much much lower this year compared to last for us, and many funds with no cap gains distributions at all.

BTW there is a thread on 2022 end of year fund distributions.

 

[Sue J]

Much much lower this year compared to last for us, and many funds with no cap gains distributions at all.

BTW there is a thread on 2022 end of year fund distributions.

Here is that thread -
https://www.early-retirement.org/forums/f28/2022-year-end-distributions-115709.html

 

[marko]

Outlier here. I love my cap gains! In addition to dividends, cap gains define what we'll spend for the coming year. Last year was our highest ever and this year ranks 4th 'best'.

(Let's not get into the dead-horse debate about dividends/CG are the same as selling shares, ok? I know that.)

 

[jebmke]

Active funds in a taxable account often inflict a lot of unnecessary pain. Same with balance funds.

 

[VanWinkle]

Cap gains are at 0% up to $83,350 for couples. Dividends are at 0% up to the same level.

That is after standard deductions(taxable income), not total income. It may be confusing for some.

 

[COcheesehead]

That is after standard deductions(taxable income), not total income. It may be confusing for some.

Math is hard taxes are harder.

 

[foxfirev5]

Outlier here. I love my cap gains! In addition to dividends, cap gains define what we'll spend for the coming year. Last year was our highest ever and this year ranks 4th 'best'.

(Let's not get into the dead-horse debate about dividends/CG are the same as selling shares, ok? I know that.)

Another outlier here. All DM cares about is what Wellesley is going to pay this quarter. Her view is that while it's not free money and it may lead or lag a little, it will reflect the market. Meaning you won't go broke by taking the distributions. At 93 yo it has worked so far. Anyway I won't argue with someone who worked for a brokerage for over 50 years.

Personally I take this approach with VG VEIRX Equity Income. However I will only hold it in tIRA or Roth. And in full disclosure DW and I have our biggest holding in VTSAX/VTI total stock market. But, dang I love the divies when they come in. Enough to live on and it completely distracts me from any drops in stock values. This is a significant positive influence on my total returns.

 

[audreyh1]

Total return investor here. I withdraw a fixed percentage every January regardless of distributions. The smaller the better in my taxable accounts as far as I’m concerned.

 

[N02L84ER]

Quote:
This year, many investors appear to have sold their actively managed funds. These sales force a fund’s manager to sell stocks to generate the cash needed to pay off departing shareholders. That creates a tax conundrum, because many funds hold stocks that enjoyed significant gains in 2020 and 2021. Selling these appreciated assets produces a capital gain. The fund can offset these gains by selling stocks at a loss. But as more people bail out of a fund, the manager may run out of losses to realize and instead must sell winners to generate cash.



Wouldn't the investor who sold the shares have to record which shares were sold and therefore have a defined capital gain (or loss) on those shares which would affect their taxes. So, having the mutual fund declare capital gains would cause double taxation, wouldn't it? I really do not understand why mutual funds declare capital gains. Can anyone explain why this would not be double taxation?

 

[audreyh1]

Quote:
This year, many investors appear to have sold their actively managed funds. These sales force a fund’s manager to sell stocks to generate the cash needed to pay off departing shareholders. That creates a tax conundrum, because many funds hold stocks that enjoyed significant gains in 2020 and 2021. Selling these appreciated assets produces a capital gain. The fund can offset these gains by selling stocks at a loss. But as more people bail out of a fund, the manager may run out of losses to realize and instead must sell winners to generate cash.



Wouldn't the investor who sold the shares have to record which shares were sold and therefore have a defined capital gain (or loss) on those shares which would affect their taxes. So, having the mutual fund declare capital gains would cause double taxation, wouldn't it? I really do not understand why mutual funds declare capital gains. Can anyone explain why this would not be double taxation?

No, once you sell your shares you don’t receive distributions. If you happen to sell them on the day the fund pays out the distribution, your realized gain will be less the distribution, so the same total amount.

The mutual fund cap gain is different than each individuals unrealized gain in the fund.

 

[N02L84ER]

"These sales force a fund’s manager to sell stocks to generate the cash needed to pay off departing shareholders."


This is the line that confuses me. "These sales" already have a capital gain amount that is (potentially) taxable to the shareholder. Why would the fund manager have to sell other shares to pay the departing shareholder.

 

[Sunset]

"These sales force a fund’s manager to sell stocks to generate the cash needed to pay off departing shareholders."


This is the line that confuses me. "These sales" already have a capital gain amount that is (potentially) taxable to the shareholder. Why would the fund manager have to sell other shares to pay the departing shareholder.

Because it's a fund, and not an ETF. Totally different structure.

ETF's are much more like stocks, you sell your ETF's does not affect me taxwise, but with funds it does.

This is why I now only buy ETF's (except wellington in my Roth/IRA) whenever I can.

Funds can give you a big declared capital gain, while the fund actually goes down in value.

 

[audreyh1]

"These sales force a fund’s manager to sell stocks to generate the cash needed to pay off departing shareholders."


This is the line that confuses me. "These sales" already have a capital gain amount that is (potentially) taxable to the shareholder. Why would the fund manager have to sell other shares to pay the departing shareholder.

The accumulated realized gain from sales of fund holdings during the year are distributed to all the remaining shareholders each year, according to the number of fund shares they own.

 

[scrabbler1]

Much much lower this year compared to last for us, and many funds with no cap gains distributions at all.

BTW there is a thread on 2022 end of year fund distributions.

My cap gain distributions have dropped a lot since 2019 when I sold off my big holding in an actively managed stock fund and replaced it with a similar index fund. One bond fund I own has an estimated $100 cap gain distribution. Another one had a $60 cap gain distribution earlier this year. That's it for my taxable account.

My IRA has no estimated CGD this year, either. The bond fund has zilch, as does the stock index fund. They have dividends, of course, as does my taxable account's stock index fund and bond funds, the latter of which provides me the cash to pay my bills.

My (snake-bit) friend's portfolio also has much smaller CGD than in previous years. He has 1 stock index fund in his taxable account and its estimated CGD has dropped twice since the initial estimate came out 5 weeks ago.

 

[N02L84ER]

The accumulated realized gain from sales of fund holdings during the year are distributed to all the remaining shareholders each year, according to the number of fund shares they own.

Sorry to be obtuse. I know it happens. I do not know why it is not considered double taxation - the same gains are taxable twice. Take the following scenario.
Person A owns 10% of Fund X, 100 shares
Person B owns 40% of Fund X, 400 shares
Person C owns 50% of Fund X, 500 shares
To make the math simple, all 3 people bought their shares at the same time for $10/share. The funds (and shareholders) basis is $10,000.
No one sells anything for a few years and the NAV increases to $15/share. The funds basis is still $10,000, the unrealized gains are $5,000, and the total value of the fund is $15,000.
Then Person B sells 100 shares at $15/share and gets a 1099B indicating they realized a LTCG of a $5/share gain on 100 shares = $500. The fund manager sold 100 shares to pay Person B and the fund now has $4,500 in unrealized gains and the $500 of realized gains. There are 900 shares remaining. $500/900 shares = $0.55556/share. So now the 3 shareholders get 1099Divs indicating Person A has a declared LTCG of $55.56, Person B has a declared LTCG of $166.68, and Person C has a declared LTCG of $277.80 for a total of 55.56 + 166.67 + 277.78 = 500.01
How is that not double taxation on the $500 of realized gains shown on the 1099B and 1099Divs?

 

[jollystomper]

I have been investing for 35+ years, so this scenario is not a new one. It becomes more of a "first world" problem.

Fortunately I do not "need" my capital gains an can choose to reinvest them (and not necessarily in the same fund).

I treat it like I treat those "surprise" year end bonuses I would get at Megacorp. Would I rather give up the bonus, or pay the tax on the bonus? I'll just have to suffer the slings and arrows of this outrageous taxation .

 

[audreyh1]

Sorry to be obtuse. I know it happens. I do not know why it is not considered double taxation - the same gains are taxable twice. Take the following scenario.
Person A owns 10% of Fund X, 100 shares
Person B owns 40% of Fund X, 400 shares
Person C owns 50% of Fund X, 500 shares
To make the math simple, all 3 people bought their shares at the same time for $10/share. The funds (and shareholders) basis is $10,000.
No one sells anything for a few years and the NAV increases to $15/share. The funds basis is still $10,000, the unrealized gains are $5,000, and the total value of the fund is $15,000.
Then Person B sells 100 shares at $15/share and gets a 1099B indicating they realized a LTCG of a $5/share gain on 100 shares = $500. The fund manager sold 100 shares to pay Person B and the fund now has $4,500 in unrealized gains and the $500 of realized gains. There are 900 shares remaining. $500/900 shares = $0.55556/share. So now the 3 shareholders get 1099Divs indicating Person A has a declared LTCG of $55.56, Person B has a declared LTCG of $166.68, and Person C has a declared LTCG of $277.80 for a total of 55.56 + 166.67 + 277.78 = 500.01
How is that not double taxation on the $500 of realized gains shown on the 1099B and 1099Divs?

I’m not going through your example to try to figure out if it is correct.

I am simply reminding you that the fund NAV drops the equivalent amount every time a distribution is paid out. And that’s why there is no double taxation on any capital gains.

The unfortunate part is that remaining shareholders are sometimes forced to pay tax on realized capital gains in the fund regardless of the reason for the fund to realize gains. Simple portfolio turnover due to finding more promising stocks can cause it. But such taxes are only paid once since your unrealized gain drops by the equivalent amount each time.

 

[NW-Bound]

It is not a double taxation.

When the MF declares dividends or cap gains, the dollar value per share goes down. If the remaining MF shareholders reinvest the distribution, their account value goes unchanged. However, the remaining cap gain of the old shares is reduced (because their value has dropped).

It's more the case of paying some tax in advance of you actually selling the shares and actually realizing the gain. When you eventually sell the shares, your tax will be lower than it would be without the MF distribution.

 

[N02L84ER]

Thanks, NW-Bound. I think I understand now.

 

[audreyh1]

It's more the case of paying some tax in advance of you actually selling the shares and actually realizing the gain. When you eventually sell the shares, your tax will be lower than it would be without the MF distribution.

That’s a good description - exactly what you are doing -paying the cap gains taxes in advance as your unrealized gain is reduced.

Keep an eye on your unrealized gain. You probably want to take a loss if it goes negative but watch out for wash sales from reinvested distributions.

 

[NW-Bound]

Many years ago, I bought into an MF in October, and got hit by a tax on a big distribution of 10% or so just two months later.

Why did I have to pay taxes on an imaginary gain that did not even show up on my account balance? It was not even an unrealized gain for me.

I was mad like heck, and only calmed down after realizing that it was only a tax prepayment.

 

[walkinwood]

These articles pop up every time we have a down year in the stock market.