Stock market booming, but beware of tax pitfalls

Can you remember how you felt two years ago? Hard to believe now, but it was a very dark time for the U.S. financial markets as the Federal Reserve’s crusade against inflation resulted in a record destruction of wealth. The “bear market” erased almost $13 trillion in market value from stocks, while supposedly “safe,” investment-grade bonds shed almost $3 trillion.

“Bear markets” (drops of > 20%) are an unpleasant, but normal part of your investment journey. In difficult times, the hardest thing for long-term investors to do is do nothing. Investors who “did nothing” have been amply rewarded for their fortitude, as the S&P 500 is up a whopping 67.8% from its bear market low on Oct. 12, 2022 and has closed at an all-time high (ATH) fifty times so far in 2024.

Hopefully, “election anxiety” didn’t cause you to sit on the sidelines, as you would have missed the best presidential election year for the S&P 500 since 1936. Further, this is one of only 18 years since 1928 where the S&P 500 was up 20%+ at this point in the year. In the prior 17 observations, the S&P 500 averaged a rest- of-year gain of 3.26% with positive returns 15 of 17 (88.2%) times.

With this constructive backdrop, you want to jump into stocks for a possible “Santa Claus” rally. Mutual fund investors need to be careful, as most funds will soon be making year-end distributions of realized capital gains, which are taxable on fund shares not held in retirement accounts (like 401-Ks or IRAs).

Like any investment owned in a taxable account, if you sell your mutual fund shares at a profit, you’ll owe capital gains taxes on the difference between the “proceeds” (i.e. the dollar amount you received) and the “cost basis” (i.e. the amount you paid).

However, taxable mutual fund investors can also incur capital gains taxes even if they don’t sell a single share. Because U.S. mutual funds don’t pay taxes and are thus required to “distribute” realized capital gains and income to shareholders at least annually, unwary investors could face an unpleasant surprise.

Funds sell securities for a number of reasons (like prices being up 70% in two years). Regardless of the reason, the fund realizes a capital gain or loss on each sale, based on the difference between the proceeds and cost.

At least annually, mutual funds tally their realized gains and losses. If there is a net gain, that amount is “distributed” to shareholders. These distributions typically occur in December. If there is a net loss, that amount is “carried forward” and used to offset gains in future years.

A fund calculates its capital gains distribution by dividing the total dollar amount of net gain by the number of shares outstanding on the “record date.” Assume XYZ Fund has assets of $100 million, five million shares outstanding on the record date of Dec. 16, 2024 and a net capital gain of $20 million. XYZ Fund has a “Net Asset Value” (NAV) of $20/share ($100 million of assets/5 million shares) and will distribute $4/share in capital gains ($20 million net gain/5 million shares) on the “ex-dividend” date of Dec. 17, 2024.

The distribution automatically and immediately causes Fund XYZ’s NAV to drop (don’t worry!) by the same $4/share to $16/share (($100 million assets -$20 million capital gain distributed=$80 million)/5 million shares).

Shareholders usually elect to reinvest the distribution in additional shares of XYZ Fund (at the new $16 NAV), but even if you don’t take the distribution in cash, you still owe the tax. So, if a shareholder owns 5,000 shares worth $100,000 (5,000 shares x $20 NAV) on the record date, she can either take a check for $20,000 ($4/share distribution, reducing the value of her investment to 5,000 shares x $16 NAV = $80,000) or reinvest the $20,000 in 1,250 additional shares ($20,000/$16 NAV=1,250), leaving the value of her investment constant (6,250 shares x $16 NAV = $100,000).

The potential tax pitfall is you receive the same $4/share distribution whether you owned the shares of XYZ Fund one day (and benefitted from NONE of the gain) or 10 years on Dec. 16, 2024. While the distribution is a non-event from an investment point of view, it can be a very big deal for taxes. Because of this, taxable shareholders should think twice about buying shares of a fund ahead of a large distribution (> 10% of NAV), like XYZ Fund’s distribution ($4/share distribution = 20% of $20/share NAV).

Funds post estimates of upcoming distributions on their websites. Alternatively, Mark Wilson’s CapGainsValet website tracks estimated fund distributions for 439 fund firms (156 of which have posted estimates). The most recent tally had 207 funds with distributions between 10% and 19% of NAV. Wilson’s “doghouse” was populated with 17 funds with distributions between 20% and 29% of NAV and 8 funds with distributions exceeding a bodacious 30% of NAV.

Check the estimated distribution of the fund you are considering before buying or the Grinch might leave an unexpected lump of coal in your stocking.

Mickey Kim is the chief operating officer and chief compliance officer for Columbus-based investment adviser Kirr Marbach & Co. Kim also writes for the Indianapolis Business Journal. He can be reached at 812-376-9444 or [email protected].