As an investor, you most likely have a clear goal in mind: to grow your wealth over time while minimizing risk. Mutual funds have long been a popular choice for investors in pursuit of this goal because they allow investors to take advantage of a diversification of assets as well as professional management. Mutual funds pool investors’ money into investment strategies utilizing a variety of assets such as stocks, bonds, and other securities. If a fund manager successfully buys low and sells high within the fund, capital gains can be generated. When these gains are distributed to investors, they are known as capital gains distributions.
The Phantom Income Tax Conundrum
The term “phantom income tax” refers to the situation where investors are taxed on capital gains distributions, even if they haven’t sold the shares of the mutual fund that they personally own. This can be frustrating for investors who see a portion of their returns eroded by taxes they didn’t anticipate or actively cause to happen.
Why Do Capital Gains Distributions Occur?
Capital gains distributions occur for a simple reason. When a fund manager buys and sells securities within their respective fund, it often leads to realized capital gains. These gains must legally be distributed to shareholders in order for the mutual fund to maintain its own tax-advantaged status. This facet of U.S. tax law can create a tax liability for investors, even if they haven’t sold their shares.
Things to Watch Out For
Be aware of the fund’s distribution schedule, which is publicly available. BentOak Capital advisors can also help find this information for you. If you buy shares just before distribution, you could be hit with a tax bill shortly after beginning your investment.
Exploring Alternative Options
If you want to minimize the impact of capital gains distributions, consider these alternatives:
- ETFs: Exchange-traded funds (ETFs) often have lower capital gains distributions compared to mutual funds, if any at all, making them a more tax-efficient choice.
- Tax-Advantaged Accounts: Holding mutual funds in a tax advantaged account like an IRA or 401(k) can eliminate the phantom income tax risk of holding a mutual fund. Because taxes are deferred for these accounts, the annual capital gain distributions do not generate phantom tax income liability.
- Tax-Efficient Funds: Some mutual funds are explicitly designed to minimize capital gains distributions, known as tax-efficient or tax-managed funds. These can be a good compromise for tax-conscious investors.
It’s important to note that potential tax issues, such as capital gains distributions and phantom income tax, are just a few of the many elements to consider when deciding what to invest in. BentOak Capital advisors can walk you through a variety of other considerations and can help personalize for you an investment strategy that considers and attempts to balances all the relevant factors.
While mutual funds offer many advantages, capital gains distributions can sometimes feel like an unwelcome surprise. Understanding why they happen, when to expect them, and exploring alternative investment options can help you navigate the world of mutual fund investing more effectively. By staying informed and proactive, you can make investment choices that align with your financial goals and tax considerations. Remember, knowledge is the key to making informed decisions in the world of investing. Read through some of the webpages linked below and contact BentOak Capital if you would like to discuss methods of investing that are both tax-efficient and in alignment with what is most important to you.
Relevant Links:
- IRS Explanation of Capital Gain Distributions: https://www.irs.gov/faqs/capital-gains-losses-and-sale-of-home/mutual-funds-costs-distributions-etc/mutual-funds-costs-distributions-etc-4
- Tax-Efficient Funds Investopedia Article: https://www.investopedia.com/terms/t/tax_efficient_fund.asp
- How Are ETFs Tax Efficient? iShares Article: https://www.ishares.com/us/insights/etfs-tax-efficient
Please remember to contact BentOak Capital (“BentOak”), in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you want to impose, add, to modify any reasonable restrictions to our investment advisory services, or if you wish to direct that BentOak to effect any specific transactions for your account. A copy of our current written disclosure Brochure discussing our advisory services and fees continues to remain available upon request or at www.bentoakcapital.com.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
Securities offered through LPL Financial, Member: FINRA/SIPC. Investment advice offered through BentOak Capital, a registered investment advisor and separate entity from LPL Financial.
