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With the end of the year in sight it’s time for year-end mutual fund distributions. If you hold mutual funds in taxable accounts, these distributions will be taxable to you.

Even with the weakness in the stock market to start the year, the Bexit vote in United Kingdom and recent pre-election weakness many mutual funds have gains embedded from a seven-year plus bull market.

Short of selling the funds, which may or may not a good idea, here are 5 tips to manage taxable mutual fund distributions.

Don’t buy the distribution

During November and December mutual fund companies will publish information about fund distributions on their websites. If you are looking to add to a position or start a new mutual fund position in a taxable account it is important that you know the dates of these distributions and take the anticipated distribution into account. You don’t want to buy a fund shortly before a significant distribution and then owe taxes on the distribution only having owned the fund for a short time.

Even if you reinvest distributions on mutual funds held in a taxable account the distributions are still taxable in the year received. These distributions can be added to your cost basis in fund which can take a bit of the sting out of this.

Consider tax-loss harvesting to offset capital gains distributions

As you go through your taxable accounts near the end of the year consider selling holdings with a loss to offset some of the capital gains distributions from your funds.

Just as with gains and losses generated from the sale of investments, long-term capital gains are matched against long-term capital losses and likewise with short-term capital gains and losses.

Tax-loss harvesting or any tax strategy should only be used if it makes sense from an investment point of view.

Index funds are not a cure-all for taxable mutual fund distributions

Index funds tracking standard broad-market indexes are generally pretty tax-efficient. That doesn’t mean that this will be the case each and every year. Further index funds and ETFs tracking small and mid-cap indexes may need to make more transactions in order to track their respective indexes.

As smart beta products become more popular they will likely be less tax-efficient than more common market-cap weighted index products. Smart beta funds will likely need to buy and sell more frequently in order to rebalance to the their underlying benchmark than more standard index products, potentially resulting in larger capital gains distributions.

Don’t let the tax tail wag the investment dog

While it is aggravating to receive large taxable mutual fund distributions, it is rarely a good idea to sell an investment holding solely for tax reasons.

Mutual fund distributions are one of three types:

Dividends

Short-term capital gains

Long-term capital gains

All three have different tax implications.

Ordinary dividends and short-term capital gains are taxed at your highest marginal ordinary income tax rate. Long-term capital gains are taxed at preferential rates ranging from 15% to 20% with higher income tax payers subject to the 3.8% Medicare tax. Qualified dividends are taxed at these same rates as well.

That said it is important to pay attention to the tax efficiency of the mutual funds that you are using in your taxable accounts.

Consider distributions when looking to rebalance

Year-end is a good time to look at rebalancing your entire portfolio, both taxable and tax-deferred accounts. As you look to rebalance your portfolio consider reducing positions in taxable mutual fund holdings that continually throw off large distributions. If the fund is a good holding look for ways to own it in a tax-deferred account if possible.

The decision with regard to the taxable portion of your portfolio always involves taxes to one extent or another. If you were looking to reduce your position in the fund anyway it can make sense to sell it prior to the record date for this year’s capital gains distribution. If selling the fund would result in a capital gain, offsetting the gain against a realized loss on another holding could be a good strategy.

The Bottom Line

With the gains in the stock market over the past few years many investors may find themselves the recipient of large distributions this year in spite of weakness in the markets over the course of the past year. When possible consider tax-efficiency when buying mutual funds in a taxable account.

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