Image source: Phillip Ingham, Flickr.
Tax season is just about to begin, and millions of Americans will be looking for ways to save on their taxes as they file their 2015 tax returns over the next several months. But there's a much bigger potential tax mistake you need to be aware of for the 2016 tax year, and by taking steps to deal with it now, you can avoid what could potentially be a costly problem down the road.
The danger of mutual fund distributions
Roughly 90 million Americans own mutual funds, according to the latest available figures from the Investment Company Institute. What many investors don't realize is that lurking within many mutual funds is a ticking tax time bomb, and if 2016 continues to go the way it has begun, that bomb could go off.
The basic problem is that mutual fund taxation doesn't work the way other types of investments get taxed. Most of the time, when you sell an investment, you pay taxes on any gains that you've earned. That makes sense, since you were the one who profited from the income.
With mutual funds, though, shareholders have to pay taxes when the fund sells assets, even if the shareholders hold onto their fund shares. The mutual funds pass through their taxable income in the form of capital gains distributions, typically at year-end.
The trap is that distributions are taxable to the shareholders who receive them, even if they didn't actually profit from the gains in the assets that the fund sold. As a result, if you buy mutual fund shares during the year, you could be setting yourself up for a big tax bill come the end of the year -- even if stocks perform badly between now and then.
Problems from 2015
Indeed, some mutual funds have already seen this problem surface at the end of last year. Perhaps the clearest example came from Fairholme Fund (FAIRX +1.46%), which sold its long-held positions in American International Group in 2015. The fund made a capital gains distribution of more than $12 per share, representing almost 40% of the fund's net asset value prior to the distribution.
If you'd bought Fairholme shares at the beginning of 2015, you would have actually seen them lose value over the course of the year. Nevertheless, you would owe taxes on gains equal to about 40% of your purchase -- even if you reinvested the distribution in new fund shares.
Why the problem could be worse in 2016 -- and how to solve it
With 2016 getting off to a rough start, the danger is that more mutual funds will lose value in 2016. At the same time, many funds with long-term holdings could look to make wholesale changes to their portfolios, finally recognizing the gains they've kept in the form of paper products over the course of the long bear market.
To avoid the tax trap from capital gains distributions, you have a few different choices. One is simply to use tax-deferred accounts to invest, as IRAs, 401(k)s, and other tax-favored investment vehicles don't have to pay tax on capital gains distributions.
Another solution is to avoid purchasing funds that have a lot of pent-up potential capital gains liability. Typically, actively managed funds are more at risk of big capital gains distributions, as index mutual funds tend to be more tax-efficient and can make their own adjustments to avoid recognizing capital gains.
Finally, if you're thinking about buying a fund, consider an exchange-traded fund rather than a traditional mutual fund. ETFs are structured in a way that protects other shareholders from the decisions the fund makes to buy and sell shares. ETF providers typically sell or redeem blocks of ETF shares not in cash, but rather with shares of the stocks that make up the ETF's holdings. That puts the tax burden from any gains on the selling institution rather than on every ETF shareholder.
It's early to be worried about taxes for next year, but investors need to keep a close eye on any mutual fund holdings they have. Otherwise, the capital gains distribution tax trap could hit them hard this time next year.
