- As mutual fund investors brace for year-end distributions, experts have tips to lessen the tax burden in future years.
- Investors should consider built-in gains before selling mutual funds, but past reinvestments may have added to the cost basis.
- You may also consider diverting payouts to ETFs, rather than reinvesting distributions into the same mutual funds.
As mutual fund investors brace for year-end distributions, experts have tips to lessen the tax burden in future years.
Certain mutual funds have capital gains payouts in November and December, which can trigger taxes in brokerage accounts, even if you haven’t sold shares. By comparison, most exchange-traded funds avoid this yearly tax issue, experts say.
“The most attractive feature of an ETF is that most don’t distribute capital gains at the end of the year,” said certified financial planner Barry Glassman, founder and president of Glassman Wealth Services in McLean, Virginia. He is also a member of CNBC’s Financial Advisor Council.
Many mutual fund families have released distribution estimates for 2023, with some paying out double-digit gains, according to Morningstar.
Here’s what to consider if you’re weighing a switch to ETFs to save on future taxes, according to experts.
Review your mutual funds’ cost basis
Glassman said many investors own mutual funds “going back years or decades” with significant gains. Selling these assets may trigger a tax bill when selling from a brokerage account. (You won’t immediately owe taxes when selling assets from a tax-deferred 401(k) or individual retirement account.)
Switching from mutual funds to ETFs may not be an advantage if there’s “a big enough capital gains hit,” said CFP Matt Knoll, senior financial planner at The Planning Center in Moline, Illinois.
However, if you reinvested past mutual fund distributions, that payout was added to the so-called “cost basis” or original price of those shares.
“There may be some purchase lots that are even or have losses,” Glassman said. “People may be able to sell those and avoid the [capital gains] distribution on those shares.”
‘Stop the madness’ and don’t reinvest
Investors with mutual funds in a brokerage account may be stuck with this year’s payout, Glassman said. But there’s an easy way to reduce next year’s capital gains distributions.
“If you’re distraught about ongoing distributions, then stop the madness,” he said. “Take it in cash and reinvest it in something similar, but more tax efficient.”
While it’s relatively quick to make the change from your account — often simply unchecking a box — Glassman said it’s a strategy that is “rarely used.”