These mutual funds are about to drop a tax surprise in investors’ portfolios

Hefty capital gains tax bills could be around the corner for investors in certain mutual funds. Fund families are notifying shareholders of estimated capital gains distributions for 2024, which they will issue to investors in December. This year has been a strong one for stocks, with the S & P 500 up more than 25% – and double-digit distributions from some mutual funds are on deck. Take the Morgan Stanley Institutional Fund Trust Dynamic Portfolio (MAAQX) , which estimates it will issue a capital gains distribution of more than half of its net asset value in December. These year-end capital gains distributions won’t be a problem for individuals who hold them in a tax-deferred account, like a 401(k) or an individual retirement account. But they will be an issue if you hold them in a brokerage account, where these gains will be subject to taxes. “It really only matters if you have the fund in a taxable account,” said Stephen Welch, senior manager research analyst and author of a Morningstar report on this year’s capital gains distributions . “If it’s in a taxable account, it may make sense to look at transitioning from one of these funds where you don’t see a big capital gains tax bill going forward,” he added. Big distributions and their taxes A shareholder in a mutual fund doesn’t have to sell down a position to incur a capital gains distribution. Drivers of these distributions include outflows from funds, where portfolio managers dump some of their holdings to cash out departing investors. A change in fund leadership or strategy can also spur capital gains as managers reshuffle a portfolio’s holdings. See below for a few funds that are expected to spin out double-digit capital gains distributions this year, per Morningstar. Similarly, active managers who tend to have high portfolio turnover can also generate capital gains as they trim their winning positions. If there aren’t enough realized losses to offset the gains, then shareholders will receive a distribution. Affected investors will receive a Form 1099 detailing a capital gain, but the upshot is that these distributions tend to be deemed long-term capital gains . Long-term capital gains can be subject to federal taxes of 0%, 15% or 20%, while short-term gains are taxed at the same rate as ordinary income – which can be as high as 37%. Minimizing the hit It may be tempting to drop a mutual fund that’s spun out a sizable capital gain, but investors should proceed with caution. Dumping the fund outright could result in even more taxes if the holding has gone up significantly in value since you bought it. “It really depends on how long have you owned the fund,” said Welch. “Have you owned it a long time? There may be a significant embedded gain in it already, and you might not want to trigger that.” Investors who like a particular fund’s style may want to gradually shift toward an ETF version that’s cheaper and more tax efficient. It’s also a good time to work with your accountant or financial advisor on whether you have realized capital losses elsewhere in your portfolio. Tax-loss harvesting , which involves selling losing positions in your portfolio and using them to offset your realized gains. If your losses exceed your capital gains, you can also apply up to $3,000 of them toward ordinary income on your federal return. You can also carry over unused losses into the future.