Navigating Tax Liabilities in a Downturn: What to Consider

The financial rollercoaster faced by investors in the Columbia Integrated Large Cap Growth Fund is a sobering reminder of the turbulent market conditions. With a staggering 22% decline in value this year, investors now find themselves liable for taxes on significant perceived capital gains amounting to 40% of their holdings.

This plight is not unique, as a combination of market downturns, the shift from actively managed funds, and the intricacies of fund distributions have created a scenario where investors may owe the IRS a hefty sum in long-term gains taxes, even during a year marked by financial losses.

Recently, Morningstar spotlighted this issue, listing numerous funds from renowned providers like American Century, Fidelity, Franklin Templeton, and T. Rowe Price expected to distribute substantial capital appreciation payments in 2022.

Here, we delve into three crucial aspects:

1. How Does the Tax Whipsaw Occur?

This phenomenon primarily impacts taxable accounts. Investors with their funds exclusively in tax-advantaged vehicles, such as IRAs, can disregard this discussion.

The basic principle governing the tax code is that a fund, as an entity, does not pay taxes. Therefore, any gains derived from stock appreciation realized by the fund should pass through to the shareholders. These shareholders, in turn, must report these gains on their tax returns.

• Example A: You buy a fund share for $20, and the stocks within its portfolio double in value, making your fund share worth $40. The fund manager sells some of the winners, generating a long-term gain of $4 per fund share. Tax regulations require this $4 to be paid out to you by year-end. At this point, your fund share's value drops to $36, you possess $4 in cash, and you owe taxes on this $4 gain.

While the tax liability may not be ideal, it mirrors the situation if you had directly purchased the same stocks and then sold some.

Importantly, whether you reinvest the $4 in the fund or not, your tax obligation remains the same.

• Example B: The same fund purchase at $20, doubling in value to $40, is met with a bear market causing the fund's value to plummet to $30. Again, the manager sells winning positions, realizing gains of $4 per fund share. These gains are distributed, leaving your fund share valued at $26, accompanied by $4 in cash and a tax bill.

Is it fair? To a degree, yes. You may owe taxes at the end of a challenging year, but you're still ahead on your fund share, plus you possess cash.

• Example C: Suppose you enter the scene late, buying the fund share for $40, only to see it drop to $30 due to the fund's previous actions. The manager sells winning positions acquired well before your investment. The gains are distributed evenly to all shareholders, leading to an unexpected tax bill, even though your investment is in the red.

In this scenario, you might be inclined to voice your concerns.

It gets more complicated. If a significant portion of the fund's shareholders leave before the distribution occurs, they receive cash at the current share price and don't bear the burden of declaring long-term gain distributions on their tax returns. It doesn't affect them. Those who entered at $20 report a $10 profit, and those who bought at $40 acknowledge a $10 capital loss.

However, for those who remain invested, the tax code mandates that the entire realized gain from the fund must be distributed. None of it gets allocated to departing shareholders. Consequently, all of it falls on the shoulders of the investors who stay. With half the shareholder base gone, the remaining investors are left with distributions not of $4 per share, but $8. If you entered at $40, your fund share is worth only $22, alongside $8 in cash and a significant tax bill.

The portfolio manager may not be at fault for this situation. The sales of appreciated stocks might have been driven by the necessity to raise cash to meet redemption requests. Mark Wilson, who tracks unwanted distributions at CapGainsValet.com, notes that much of the tax damage witnessed this year is due to redemptions.

Please note that Example C simplifies the calculation by assuming all remaining shareholders reinvest all their payouts. If they don't, the damage could be more extensive.

2. Defensive Strategies to Consider

In Examples A and B, it's best to hold your position. Selling the fund would only worsen your situation, as you'd have to pay taxes on both the gain distribution and the fund share's gain.

In Example C, however, it's wise to exit the fund. Your tax return would reflect an $8 distribution and an $18 loss on the fund share (purchased at $40, sold ex-dividend at $22), resulting in a net capital loss of $10.

Could you enhance your position by selling just before the distribution? Unfortunately, no. You'd still incur a $10 loss (acquired at $40, sold at $30).

What if you purchased the underperforming fund less than 12 months ago? This opens the possibility of receiving $8 in long-term gain (the preferred type) while recording an $18 short-term loss (the favored loss). While it might seem like an attractive arbitrage, tax regulations dictate that, in this scenario, the first $8 of your short-term loss on the fund share converts into a long-term loss. As a result, whether you exit before or after the distribution, you'll still have a $10 short-term loss.

• Example D: You bought the fund years ago at $21, witnessed it rise to $30, and now face an unwanted $8 distribution. What's the best course of action?

Exiting would mean owing tax on $9 of capital appreciation ($1 from selling the fund share and $8 from the gain distribution). Holding your position, however, requires taxes on only $8 of gain but entails future distributions. The recommended approach is to sell the fund, pay a slightly higher tax now, and invest the proceeds in a different type of stock fund that does not issue distributions.

To summarize, if your fund share, following the payout, is worth significantly more than your initial investment, it's advisable to remain invested. If it's worth less or only marginally more, exiting is the wiser choice, and the timing of your exit concerning the distribution doesn't matter.

One additional note to address concerns about the timing of your exit in relation to the distribution: If the fund reports short-term gains, it's better to exit before the payout. Short-term gains from an investment company are taxed as ordinary income, akin to interest income, which is less favorable. However, it's crucial to emphasize that significant short-term gain distributions are rare and typically not a cause for concern.

3. Preventing Future Whipsaw Damage

Many financial advisors caution against investing in an equity mutual fund toward the end of the year to avoid purchasing unwanted distributions. While this advice has merit, it may not go far enough.

Here's a stronger recommendation: refrain from investing in an equity mutual fund for a taxable account altogether.

Join the ranks of several trillions of dollars in smart money that have recently shifted toward investing in exchange-traded funds (ETFs) tracking indexes like the S&P 500. ETFs organized as stock index funds almost never distribute capital appreciation.

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