By Ashlee Ogrzewalla, CFP®, CFDA®, Vice President and Manager of Financial Planning & Marketing
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’Tis the season for capital gains distributions. Mutual fund companies must provide investors with estimated income and capital gains distributions each year, offering insight into potential tax liabilities. These distributions have been posted and are beginning to hit investors’ accounts as we finish the year.
Across many asset classes, 2024 proved to be strong. Large-cap growth funds excelled in equities, driven by the ongoing artificial intelligence boom and standout performers. Although large-cap value funds lagged behind their growth counterparts, they still delivered impressive cumulative returns exceeding 15% (Morningstar.com), underscoring solid performance in a competitive market.
When reviewing your mutual fund account statements, it’s essential to understand the types of distributions you may encounter. Let’s break down these distributions and explore strategies to manage their impact effectively.
Types of Mutual Fund Distributions
Securities held within mutual funds can generate capital gains and earn dividends throughout the year. Mutual funds are required to distribute any net capital gains and accrued income to their shareholders at least annually.
These distributions can be reinvested back into the fund or paid out, but the choice does not affect the distribution’s taxable status. Distributions made by mutual funds held within tax-advantaged accounts, such as IRAs or 401(k)s, are not subject to taxation.
There are four primary types of mutual fund distributions:
1. Capital Gains
These occur when the fund sells securities for a profit, distributing gains when realized profits outweigh losses. These distributions are categorized as either short-term or long-term gains. Short-term gains stem from securities held for less than one year, while long-term gains result from securities held for over one year. The tax rate for long-term capital gains varies from 0% to 20%, depending on the shareholder’s tax bracket. In contrast, short-term capital gains are taxed at the shareholder’s ordinary income tax rate.
2. Dividends
Dividends are cash distributions stemming from stock ownership. Dividends paid on securities held within the fund are typically accrued by the fund and distributed monthly or quarterly to shareholders. These ordinary dividends are taxable at the shareholder’s income tax rate. Some mutual funds make qualified distributions with a preferred tax rate of 15%.
3. Interest
Interest usually arises from fixed-income securities like bonds and certificates of deposit (CDs). Interest is accumulated and distributed like equity dividends and taxed at the shareholder’s ordinary income tax rate. From a mutual fund standpoint, ordinary dividends and interest are essentially treated the same.
4. Return of Capital
A return of capital distribution occurs when the fund returns a portion of the investor’s original investment. This return of capital is not a taxable event and is neither classified as a dividend nor capital gain distribution. Return of capital distributions are most common with real estate investment trusts (REITs) and master limited partnerships (MLPs).
Tax-Smart Strategies for 2024
Managing the tax implications of mutual fund distributions requires proactive planning. Here are some tips to help you stay ahead:
- Avoid Taxable Distributions from New Investments: Avoid making significant new investments in a mutual fund shortly before it distributes capital gains. Doing so could result in an unexpected tax bill.
- Monitor Unrealized Gains and Losses: Review your account statements or the fund company’s website for information on unrealized gains or losses. This insight helps you anticipate potential distributions.
- Leverage Tax-Advantaged Accounts: Consider holding mutual funds in tax-deferred accounts, such as IRAs or 401(k)s, to defer or eliminate tax implications of distributions.
- Work with a Financial Advisor: Your advisor can help identify the most tax-efficient investments for taxable and tax-advantaged accounts.
Key Considerations for 2024
The tax efficiency of mutual fund investments plays a critical role in maximizing after-tax returns. Understanding distribution types and implications enables smarter decision-making and better portfolio management. By employing thoughtful tax strategies and working with your financial advisor, you can position your portfolio to minimize tax burdens while aligning with your financial goals. Be prepared, stay informed, and take control of your investments when wrapping up 2024 and looking ahead to next year.
IMPORTANT DISCLOSURES: The information provided is based on internal and external sources that are considered reliable; however, the accuracy of this information is not guaranteed. This piece is intended to provide accurate information regarding the subject matter discussed. It is made available with the understanding that Benjamin F. Edwards is not engaged in rendering legal, accounting or tax preparation services. Specific questions on taxes or legal matters as they relate to your individual situation should be directed to your tax or legal professional.