For this 2021 tax season we at Northstar Financial Management fielded one question more than any other: I didn’t sell investments or take distributions in 2021, where did all of these capital gains come from? No, you probably didn’t make trades or take distributions and forgot about it. There was something else at play in 2021 that is a common occurrence when investing in mutual funds.
To start, the basic definition: You earn capital gains when you purchase an asset at one price and sell it at a higher price. The gain you make on that sale is income, so it is taxed, but it is taxed at a different rate from other income, like the wages you earned from your 9 to 5 job.
The most common capital gains you’ll see on your tax return comes from buying stock as an investment and selling it at a profit. Capital gains are only created when a sale occurs – if the stock is currently trading at a higher price than where you bought it, you don’t pay capital gains tax unless you sell the stock and actually receive the income from that sale. This is why, when you see capital gains tax on your tax return your first thought is likely to be “did I sell something and forget about it?”
However, there is another type of capital gain that is taxed, called capital gains distributions. This year we saw big capital gains distributions for clients who have investment accounts. The reason you didn’t know about those capital gains ahead of time is that YOU didn’t sell the investment and neither did Northstar – the mutual fund or ETF did.
Quick reminder: Mutual Funds and ETFs are investment vehicles that you buy, similar to how you might buy a company stock. But when you buy a share of a mutual fund or ETF you’re actually pooling your money with other investors who bought shares in the fund. Then the fund invests the money in a diverse portfolio of securities such as stocks, bonds, and short-term debt. The fund holds this pool of money and buys and sells the stocks according to its investment strategy. When the fund sells the investments it holds, it passes those proceeds out to the investors as capital gains distributions, similar to how a company would issue a dividend to its shareholders.
When an individual taxpayer owns a mutual fund and that fund distributes capital gains to its investors, each investor must report those capital gains on their individual tax returns and pay capital gains tax.
But why don’t I remember getting a capital gain distribution from my mutual funds? I would have spent that on something fun! The funds aren’t distributed to you, they’re reinvested within the fund to purchase new investments. This keeps your money invested, so it can continue to earn more in the future.
Why would a fund make capital gains distributions? Why so many in 2021?
1. Strategic reasons. Funds have an investing strategy (for example, “large cap” or “developing markets”) and they buy and sell securities in line with that strategy. If the fund manager decides to change their investing strategy she would have to sell and buy new securities in line with the new strategy. Or if one of the fund’s securities drifts away from the fund’s strategy (a small cap company grows into a medium cap company, for example) then the fund might choose to sell that security.
2. Cash outs. Sometimes a large number of investors choose to cash out of a fund, causing the fund to have to sell some investments in order to satisfy the cash out of those investors.
3. Rebalancing. When the direction of the market changes, the fund may need to sell securities to rebalance. The significant growth in the capital markets last year, after several prior years of strong growth, led to many mutual funds having to rebalance their holdings within the fund in 2021, and selling stocks that have been held over several years with significant appreciation.
Can I prevent capital gains?
Yep, stop making money. Actually, I’m serious – you only incur capital gains tax when you make money, so if you want to avoid capital gains tax then invest in things that won’t make money. You can see how that might run counter to your investment strategy, and any investment strategy that Northstar would recommend to you.
Can I at least REDUCE capital gains?
Since capital gains happen when a sale is made, you can minimize them by investing in index funds or ETFs that have a less active strategy - this will reduce the transactions within the funds in most years. This is something Northstar takes into consideration when we choose funds and ETFs for our portfolios – we want funds that will perform well in a tax efficient way. This goal has led us to start to replace some of our managed funds with index funds that are more tax efficient. We’re finding that the activity level of a fund is an important consideration that we’ll be acting on even more going forward.
It’s worth pointing out that you do not pay capital gains tax on funds that are in a traditional or Roth IRA, since you aren’t paying tax on the growth of the funds as it happens, only when you pull money out, down the road. Investing within an IRA account or other qualified retirement savings account can be a good way to delay paying capital gains tax until you actually get to use the money. But there is a limit on how much can be socked away in one of these types of accounts, which leads many investors to supplement those tax deferred accounts with other taxable accounts for the amounts they want to invest over the qualified account maximums.
But remember that IRAs are only a temporary solution - the purpose of saving money is to spend it someday and when that day comes you’ll pay the tax on whatever you’ve earned in that account. In the end the Roth IRA is the only solution in which you truly avoid paying tax on your earnings, but with a $6,000 limit in 2022 there’s only a limited amount of assets you can protect using this vehicle.
In the end, what is most important is refocusing on the fact that you made money and that’s what you want your investments to do. Reacting to the tax bill by moving your money where it will earn less and incur less tax doesn’t make a lot of sense when you view it that way.