Capital Gains Distributions not a good income stream?

[BeanCounter62]

Most of my taxable investments are in Wellington - VWENX.

Took falling off the ACA cliff a few years ago to start questioning the Capital Gains distributions. I no longer expect any subsidies. I also stopped the automatic reinvesting after that.

I thought the CG and dividends payouts each year were a good thing as an income stream. Even if I had to pay taxes on the income, it's still extra $$$ - in addition to the shares I own.

But there is so much talk about NOT wanting CG distributions. Isn't it just another income stream like dividends?

Who can explain to me why shares like a combo of Vanguard Total Stock / Total Bond without the CG payouts are considered more advantageous than Wellington?



Other details:
I am 57 - file Head of Household (with a 16 year old at home)

Income from Rentals and Investment Income cover my annual expenses .

$1M tIRAs will only add to that income <debating ROTH conversions >

[audreyh1]

No, it’s not extra money. Capital gains distributions are not income like dividends, they are a forced sale of some of the unrealized gains in the fund meaning you have no control over when to take those gains. It’s an unwelcome “feature” of traditional mutual funds. If you are a traditional income investor you are supposed to immediately reinvest those cap gains distributions, you just get to pay the taxes on them!

And you might not even have unrealized gains in a given fund yourself, but you are forced to pay taxes anyway as if you did have gains, unless you are smart enough to realize that you can take a capital loss to offset the distribution by selling the fund.

I‘m a total return investor and I rebalance in Jan when taking my withdrawal, so most years it works out as usually it’s the funds that have the most gains that pay the highest cap gains distributions. I would have probably had to sell some of the fund anyway to rebalance. But occasionally the situation arises where a fund pays a large cap gains distribution even though it had a poor year, and that’s very annoying. If an active fund pays out so much in cap gains distributions over a few years such that the remaining unrealized gains are approaching 0 or turn into a loss, I usually get rid of it and swap for a more tax efficient index fund.

If you are using a balanced type fund in taxable accounts for the convenience (ease of use), unfortunately you are at the mercy of whatever cap gains they pay annually, and that can be driven by outflows from the fund caused by the other investors who sold the fund that year - a net exodus. But can also be caused by the fund manager taking profits, rebalancing, or otherwise changing positions during the year. Balanced funds are not generally very tax efficient since they are frequently rebalancing. But that is probably what the investor wanted. It’s just a bit tough when you are targeting say a 4% withdrawal, but the balanced fund is paying out say 10% in total distributions. You have to pay taxes on that 10% even though you are turning around and reinvesting the extra 6% paid out. But maybe stocks ran up so much that year that rebalancing yourself would have caused that larger cap gain to be realized anyway.

Many people use ETFs to avoid this nasty side effect of traditional mutual funds. They may still have to take some profits to rebalance, but at least they have complete control over it. ETFs aren’t generally an option for balanced funds - Vanguard doesn’t offer them, although I see that iShares offers some. You’d have to own stock and bond ETFs and do the rebalancing yourself to avoid cap gains distributions. And you still might realize large gains yourself due to rebalancing during a long bull run.

My long rambling answer perhaps indicates that there are many aspects to consider with respect to your investing goals.

[Andre1969]

I always looked at capital gains as sort of an unreliable dividend. They usually only pay out once per year, and usually, at the same long term capital gains rate that a qualified dividend pays out. They do reduce the per-share value of your mutual fund, but you still have the same amount of shares, just at a reduced price. But, with an individual stock that pays dividends, the dividends reduce the per-share value of the stock, as well.

The main difference, the way I see it, is that a stock usually pays a consistent dividend 4 times per year, and that dividend usually grows year after year. With a mutual fund, it's only once per year (although some of them do ST capital gains several times per year), and it's never the same amount year after year.

The timing can be annoying with mutual funds, as well. For instance, if a fund has a really good year, sometimes the manager will churn some off its holdings early the next year, to lock in those gains. But, if later in that year, the market crashes, they'll still declare a capital gain at the end of the year, even though your overall value is down. At least, that's how I think it works. I've noticed in the past that sometimes I'll have a lot of capital gains in an off year, and not much in a good year.

[scrabbler1]

In the 11 years I have been retired, and living off my investment income, I have been taking my monthly bond fund dividends in cash. And since 2014, I have been taking the quarterly stock fund dividends in cash. Any cap gain distributions have been erratic, so I reinvest them, and pay the income taxes from the dividends.


But like you, BeanCounter62, I have been thrown off the ACA cliff the last 2 years when my main stock fund spewed CG distributions that were enormous. This year's upcoming distribution is estimated to be smaller, so it looks like I can barely manage to keep from going over the cliff and obtain the ACA subsidy, whose value has been growing the last few years. Because the distributions were so big, I had to take them in cash so I would have the cash available be able to pay the taxes on them.


If I am about to go over the ACA cliff in a future year and can't prevent it, I will just bite the bullet and sell the entire stock fund holding and buy an stock index fund. The stock fund I am in now I began buying back in 1996, years before I retired and years before the ACA (and years before I knew more about stock funds), and it has a huge, unrealized cap gain which would cost me much more in taxes than any ACA subsidy would save me. I do have a stock index fund in my tIRA, a rollover IRA from my old 401k. To maintain my stock distribution, I might do the opposite move, selling it and buying into the managed fund I would be vacating in my taxable account. That would not be a taxable event.

[mrfeh]

Quote:

Originally Posted by BeanCounter62 I thought the CG and dividends payouts each year were a good thing as an income stream. Even if I had to pay taxes on the income, it's still extra $$$ - in addition to the shares I own.

It's not extra money. The NAV of the fund falls proportionally when a distribution is made.

[RetiredAt55.5]

Quote:

Originally Posted by scrabbler1 If I am about to go over the ACA cliff in a future year and can't prevent it, I will just bite the bullet and sell the entire stock fund holding and buy an stock index fund. The stock fund I am in now I began buying back in 1996, years before I retired and years before the ACA (and years before I knew more about stock funds), and it has a huge, unrealized cap gain which would cost me much more in taxes than any ACA subsidy would save me.

I'm in a similar situation. I have 2 taxable stock funds with large distributions each year. In fact, they are the largest component in my income stream. I bought them in the early 90's, before the advent of ETF's, so selling them all isn't an option due to ACA and the tax hit.

I guess I'm lucky since I'm not that close to the cliff. The one good thing about a part time job in retirement and the ACA is that I have the option to pull the IRA contribution lever.

The one thing I wish I'd done sooner (before retiring), would've been to turn OFF reinvesting distributions. I think that should be on a checklist for pre retirees as something to consider.

[audreyh1]

Yes, I quickly learned to turn off automatic reinvesting of distributions in my taxable accounts.

Just to be clear - no issues with automatically reinvesting distributions in tax-deferred accounts.

[UnrealizedPotential]

I kind of do things a little different maybe. For one thing I don't mind reinvesting the capital gains in my Roth Ira and T Ira. It's not a taxable event for me. As for the ACA cliff, I am not even close to hitting it. But I am planning on moving overseas anyway so I am not worried about the ACA long term.

My other accounts are pretty much ETF's and they usually don't have capital gains. Well, my bond fund which is a taxable account, I reinvest the capital gains. I thought about taking the distributions but it's no big deal to me. I may change course in the future, but for now that is what I do.

[pb4uski]

CG distributions are paying out to fundholders a portion of the fund's realized gains for the year... since the gains have been realized the fund has the money... when it is distributed the NAV goes down by the CG distribution per share so ignoring taxes it is indifferent to the shareholder.

I prefer index funds in taxable accounts because I can control my income and taxes better. Mixed funds like Wellington are better for tax-deferred or tax-free accounts IMO.

[Which Roger]

Quote:

Originally Posted by BeanCounter62 Who can explain to me why shares like a combo of Vanguard Total Stock / Total Bond without the CG payouts are considered more advantageous than Wellington? >

Because index funds give you complete control over when capital gains are realized. This in turn gives more control over income when trying to manage it to stay away from the subsidy cliff, or for any other reason. You will still have dividend income, but dividends are more predictable.

[MarieIG]

I kicked two of my mutual funds to the curb this year (yes I checked the basis first) after they spewed huge capital gains last year; and I got a year end statement telling me that the funds were worth significantly less money at the end of the year than the beginning.

So, at that end of the year I got to pay tax on that money (including NIIT- which I did not even know about until reading about it on this board) and had no money in my pocket from it.

Bottom line, it did not seem particularly tax efficient to me; and I am trending towards ETFs.

[Chuckanut]

Quote:

Originally Posted by audreyh1 Yes, I quickly learned to turn off automatic reinvesting of distributions in my taxable accounts.

It sounds like you have reinvestment turned off for both dividends and capital gains. True?

I have my dividend reinvestment turned off. But, currently, I am reinvesting capital gains distributions. I don't quite understand why one needs to turn off capital gains distributions if one is in it for the long run or at least a longer run).

[W2R]

I feel free to spend my dividends if I wish to do so, but I choose to re-invest any capital gains. The way I look it is, is that capital gains have to be re-invested in order for my investment portfolio to keep up with inflation.

I don't regard capital gains as an income stream for retirement spending.

[audreyh1]

Quote:

Originally Posted by Which Roger Because index funds give you complete control over when capital gains are realized. This in turn gives more control over income when trying to manage it to stay away from the subsidy cliff, or for any other reason. You will still have dividend income, but dividends are more predictable.

It might also be useful to notice that large-cap equity index fund total distributions tend to be on the order of 1-2% (mostly qualified dividends), whereas this year balanced funds seem to be more like 10%. This is a massive difference, even when taking into account the 2.5-3% dividend income generated by the bond portion of the balanced funds.

[audreyh1]

BTW Vanguard Wellington VWENX estimated capital gains distributions are 2.24% of NAV (Oct 30 NAV?)

This is quite small and I seriously doubt you could improve much upon it as a retiree needing to withdraw some funds annually anyway.

[FANOFJESUS]

About the Wellington
I know what you mean this looked tempting to me

https://www.youtube.com/watch?v=m3UuOLT1YZs&t=89s

[stevemac]

Thanks to everyone for their input on this, and I am a little confused on the ETF vs. Mutual Fund angle to this as it pertains to auto-reinvesting. At TDAmeritrade I have a taxable and a tax-deferred account; also have an SEP at Schwab.

I plan to retire next year, and currently have all dividends and CG reinvested in all 3 accounts. Also will join ACA next year for the first time. I think the most pertinent question is whether there is a fundamental difference between ETF and MF when deciding whether to do auto-reinvest. For example, VTSAX vs. VTI, and does it matter whether the account is taxable or tIRA/SEP?

Thank you very much.

[mrfeh]

Quote:

Originally Posted by stevemac Thanks to everyone for their input on this, and I am a little confused on the ETF vs. Mutual Fund angle to this as it pertains to auto-reinvesting. At TDAmeritrade I have a taxable and a tax-deferred account; also have an SEP at Schwab. I plan to retire next year, and currently have all dividends and CG reinvested in all 3 accounts. Also will join ACA next year for the first time. I think the most pertinent question is whether there is a fundamental difference between ETF and MF when deciding whether to do auto-reinvest. For example, VTSAX vs. VTI, and does it matter whether the account is taxable or tIRA/SEP? Thank you very much.

My rules of thumb:

1. taxable account: don't auto-reinvest anything
2. tax-advantaged accounts: reinvest everything

If you don't spend the distributions in your taxable account, use them to rebalance. You'll want to use tax efficient mutual funds/ETFs in your taxable accounts.

[youbet]

Quote:

Originally Posted by audreyh1 Yes, I quickly learned to turn off automatic reinvesting of distributions in my taxable accounts. Just to be clear - no issues with automatically reinvesting distributions in tax-deferred accounts.

Help me understand this Audrey. It doesn't seem like there would be any difference between automatically reinvesting in taxable accounts or not from a tax perspective. If the fund pays a distribution, it's taxable whether you automatically reinvest or not, right?

Now, as far as directing the reinvestment of fund distributions to achieve your target AA, then that's a good reason to not do automatic reinvestment.

Do I have that right?

[mrfeh]

Quote:

Originally Posted by youbet Help me understand this Audrey. It doesn't seem like there would be any difference between automatically reinvesting in taxable accounts or not from a tax perspective. If the fund pays a distribution, it's taxable whether you automatically reinvest or not, right? Now, as far as directing the reinvestment of fund distributions to achieve your target AA, then that's a good reason to not do automatic reinvestment. Do I have that right?

Yes, you have it right.

Another reason to not reinvest in taxable is that if you ever need to sell, you won't need to worry about wash sales.