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Jim, Should I Hold On To A Mutual Fund To Save On Capital Gains?

Jim, I have a mutual fund that I really would like to sell since I am trying to get completely out of the stock market right now.  My broker is trying to get me to hold the fund since if I sell, it will trigger capital gains taxes, is this true?

First, most financial decisions should not be made solely on the basis of tax consequences.  This becomes the proverbial “tail wagging the dog”.  Tax consequences should be considered as an overall part of the equation when deciding to sell an investment subject to capital gains, but not the only consideration.

A Brief Review of Capital Gains Taxes

If you purchase a stock for $10 per share and sell for $13 per share, you have just made $3 per share.  This profit, is taxed as a capital gain.  If you did not sell the stock, you would still have a paper profit of $3, but this would not be taxable until such time as you actually sell the stock and realize the gain (the reason so many people wait to sell their winning positions until after Jan 1 each year).

In the case of a mutual fund, taxes are handled differently.  Mutual funds are required to distribute their realized capital gains each year.  This usually happens in November or early December.  You may not notice this if you have your mutual fund set up to reinvest all dividends.  Nonetheless, all of the profit realized by your fund (the stocks they sold at a profit), will be distributed to you and you will owe capital gains taxes on this distribution.  As a mutual fund investor, you do not enjoy the same opportunity to delay these capital gains as if you owned an individual stock.

Holding On To A Losing Mutual Fund To Delay Capital Gains Taxes Makes Little Sense

Holding onto your mutual fund position for tax reasons is not usually a good strategy.  There may be some rare exceptions to this if the fund you own has a low turnover rate.  This means that they buy and hold the stocks in their portfolio for the long run and don’t sell very many of them throughout the year (an index fund would be an example of a low turnover rate type of fund).  If you own shares in a mutual fund that takes a buy and hold approach, they may not be distributing very much of their gains each year through a dividend.  If this is the case, your situation may be comparable to owning an individual stock (as outlined above).

To find out more about this issue, call your fund ask them what the capital gains dividend was for this year.  Also inquire about their portfolio turnover rate.  For example, if the turnover rate is 86% that would mean that they sell on average 86% of their portfolio throughout the year.  In this example, virtually all gains are realized each year.

The benefit of holding onto a mutual fund for tax purposes is usually minimal and certainly no reason to justify changing your investment strategy or sticking with a losing fund.

Agree or disagree, click on comments below.

Helping you make the most of God’s money!

James L. Paris
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