U.S.-based growth mutual funds and value funds are set to pay out significant year-end distributions, with many funds estimating that payouts to fundholders will range in percentages of net asset value (NAV) from the high single digits to double digits, according to a report from Chicago-based research firm Morningstar, Inc. Most fund firms pay out year-end distributions in early- to mid-December.
“The taxes owed on those payouts could be the fly in the ointment of an otherwise satisfactory year for investors who hold their funds in taxable accounts,” stated the report released Wednesday.
According to the report, the combination of another strong year of returns and a continuing trend of investors swapping out of active products in favour of ETFs and other mostly passive products led fund managers to realize gains in order to rebalance portfolios and meet redemption requirements. The average U.S. equity fund was up 21.1%, and the typical non-U.S. strategy gained 9.6% as of October 2021.
A U.S. investor receiving distributions from a fund held in a taxable account will owe tax on distributed gains, even if the distributions are reinvested, unless there are offsetting losses available from the sale of losing investments. (Distributions from funds held in non-taxable accounts do not represent a taxable event to the investor.)
On the other hand, capital gains reinvested in the fund increases the cost base of the fund, which might reduce capital gains taxes owed when the fund is eventually sold.
A number of U.S. asset managers have recently published their funds’ year-end distribution estimates. For example, T. Rowe Price reported that the T. Rowe Price New Horizons fund, a U.S. equity growth fund, will pay out a distribution of an estimated 13% of NAV, while Dimensional Fund Advisors reported its DFA U.S. Micro Cap fund will pay out an estimated 11% of NAV.
Investors might consider delaying purchasing a fund expected to make a distribution until after the payout is made in order to avoid receiving distributions without the benefit of any of the gains, the Morningstar report’s authors suggested.
Canadian investors who own U.S.-based mutual funds in a non-registered account have to report any dividends received from the fund, after currency conversion, on their Canadian tax return. As well, there may be additional U.S. withholding tax charged on the distribution. However, a foreign tax credit may be available to offset the U.S. withholding tax, depending on how the fund is held.