December is typically a time of cheer, but that’s not always the case for mutual fund and ETF investors.
Every December, Vanguard’s funds, like all funds and ETFs, must pay out all the interest, income and capital gains accumulated over the calendar year. This isn’t a choice; it’s a legal requirement.
If you’re already an expert on capital gains and how they impact your portfolio, congrats! However, it never hurts to get a refresher from time to time. And as we’re now entering capital gains season, what better time to review and refresh?
In this article, I will cover the basics, define some key terms and give you two simple strategies to follow. I’m calling this Capital Gains 101, and I’ll discuss more complicated strategies in Capital Gains 102.
As you might expect, each capital gain distribution season differs slightly from the prior one in exactly when and how much each fund pays out in capital gains. So, it’s incumbent upon me every year to provide IVA readers with all the dates and data they need to navigate the upcoming distribution season confidently.
This article is the foundational knowledge that will allow us to get to the details in each annual update with less preamble.
One reminder before I get into it: When it comes to retirement accounts (IRAs, 401(k)s, etc.), you don’t have to worry about capital gains—distributions, whether they are capital gains, income or something else, aren’t taxed until you withdraw your money. I’m talking about investments in taxable brokerage accounts, which is where you must pay particular attention during distribution season.
With that said, let’s dive in.
Key Points
- Mutual funds and ETFs must pay out dividends, interest and net trading profits (capital gains) every year.
- If a fund is poised to distribute and you own shares on its record date, you will receive that distribution.
- Don’t buy a fund (in your brokerage account) right before it is scheduled to pay out capital gains.
- Automatically sending distributions to cash can be an efficient way to rebalance and manage your taxable portfolio.
Capital Gains 101
Mutual funds and ETFs must (by law) distribute to shareholders any capital gains they have realized (plus the interest and dividends they’ve received) at least once a year during that same calendar year.
Dividends and interest are straightforward. If a stock pays a dividend, the mutual fund passes that dividend on to shareholders. If a bond pays interest, that interest gets passed along as well. Mutual funds typically extract their expenses from the interest and dividends received in their portfolios first, so what’s left over is money that will be distributed to shareholders.
Capital gains, the net trading profits the fund generated during the year, are trickier.
In all funds, even index funds, the portfolio manager buys and sells stocks, bonds, or maybe both throughout the year. When a position is sold, it is either sold at a profit or a loss. If the profits outweigh the losses when the fund tallies up those trades near year-end, then the net “capital gains” must be distributed to shareholders.
If there is a net loss, shareholders can’t claim those losses on their own tax returns. However, the loss carries over into the fund’s next tax cycle, reducing future capital gain distributions.
A+ for Vanguard
To its credit, Vanguard leads the industry in transparency on capital gains. Every month, Vanguard reports on the current capital gains status for each of its funds, indicating the net profits (or losses) each fund has generated for the year.
I’m unaware of any other fund company that does this, and I applaud Vanguard for it.
As year-end approaches, Vanguard provides additional estimates for what investors can expect to receive in capital gains. I share Vanguard’s estimated distributions in a user-friendly format and provide further analysis and commentary every year.
However, you can visit the Tax Center on Vanguard’s advisor website if you want to go straight to the source.
Key Dates
For tax-smart investors, though, it isn’t enough simply to know the size of any expected distributions; there are some important dates you need to keep in mind: