Don’t Pay This Tax!
Vanguard just released its preliminary capital gain distribution schedule for its funds. As expected, in this LONG bull market, many of the actively managed funds will have large capital gains distributions.
This means more tax for you if you hold these funds in a taxable account.
How You Pay Taxes on Mutual Funds
Mutual Funds hold dozens, even hundreds, of stocks or bonds in their portfolios. Sometimes, throughout the year, the manager will sell a stock or bond for a price higher than what he purchased it for. This results in a capital gain.
That capital gain is paid out the actual shareholders of the fund, typically in December. Those shareholders who receive the capital gain must pay tax on that distribution if the fund is held is held in a taxable account. (If the fund is held in tax-qualified accounts such as an IRA or 401k you don’t pay tax on the capital gain distribution.)
So, even if you’ve never sold any shares of your fund, even if you are actually DOWN in value on YOUR investment in the fund, you will still have a taxable distribution because of those capital gains
Let me give you an example.
You buy fund ABCDE for $100,000 in 2017. At the year end of 2019, the value has dropped to $98,000. You are down $2,000. Well that stinks. But that’s the nature of investing in mutual funds, right?
But then, in January 2020, you receive a 1099 showing the fund paid out a Capital Gain distribution of 5% of its assets in December 2019. This means YOU will have to pay tax on that $5,000 capital gain, even though you are down in the portfolio!
“Wha, wha, what???? How the heck does this happen?” You ask. It’s simple really. If the fund has been around for any period of time, it’s got some serious UNREALIZED CAPITAL GAINS built up in it.
The image above shows the Vanguard Capital Opportunity Fund has nearly $10.5 BILLION of unrealized gains! And that is as of Sept. 2018, wait until the new annual report comes out given the huge market gains in 2019. The amount of unrealized gains will probably grow another 10-15%.
SOMEONE has to pay tax on those gains when they are realized, i.e., when the fund managers decide to sell a position that has increased in value relative to the price they paid for it. That someone is YOU, the fund shareholder. And you’ll pay tax on that capital gain regardless if your individual holding is up, down or sideways.
I can’t even begin to tell you how many times people have complained to me that they have to pay tax on their mutual funds even though they are down on the total balance of their account. Welcome to the double taxation of Mutual Funds. Fun, isn’t it?
Of course not. But being ignorant of the tax treatment of mutual funds doesn’t absolve you of having to pay the tax. So, best be forewarned.
Vanguard Capital Opportunity Fund (VHCAX, VHCOX)
This fund, run by the folks who run the highly-regarded PrimeCap fund, will pay 5.58% of its portfolio as taxable capital gain distributions. This means for every $10,000 you own you’ll receive a taxable distribution of $558.
Now, don’t think you’re out of the woods just yet, either.
Last year this fund had a dividend distribution of .93% of the Net Asset Value. Thus if you owned $10,000 in the fund you’d have to add another $93 to your taxable distribution as a dividend.
In fact, last year your total distributions were more than 12% of the portfolio value:
That means on that $10.000 position you owned in Capital Opportunity you’d receive total taxable distribution of $1,200!
Vanguard Diversified Equity Fund (VDEQX)
This fund-of-funds, in that it invests in other Vanguard actively managed funds, will pay out 6.71% of its assets by year end. That means for every $10,000 you own, you’ll receive a taxable distribution of $671. And that is just the capital gains alone. Last year it ALSO paid dividend distributions of around 1.25%.
Vanguard Health Care Fund (VGHAX, VGHCX)
A perpetual rock star of Vanguard’s funds, run by the good folks at Wellington, this fund will pay out 6.82% of its assets by year end. Oh, but the good times don’t end there. It also paid 4.15% back in March as a Supplemental distribution to shareholders. Thus, all told, investors will receive over 11% in 2019 as taxable distributions.
Don’t forget the dividend too. Last year it paid out $2.18 per share.
Vanguard Mid-Cap Growth (VMGRX)
Whooooweee! This fund is going to pay out 11.14% of its assets as taxable capital gain distributions. That is on top of the nearly 14% it paid out last year. This fund is generating some serious taxable distributions. Thankfully, it only has a dividend yield of .33%. So the dividend won’t add much to your taxable distributions.
Vanguard Primecap (VPMCX)
Another of Vanguard’s actively managed rock stars. This fund will pay out just under 6% of its total assets in taxable capital gain distributions. So, for every $10,000 you own, you’ll have to declare $580 as taxable capital gain income
Add another 1.26% for the dividend and you’re looking at over a 7% taxable distribution.
Scary thing about this fund is that 55% of the portfolio is unrealized gains. That means unless we hit a serious market skid, this fund will continue to pay heavy distributions for as far as the eye can see.
Nothing wrong with that of course. Taxes means you made money, right? Well, not in the wonderful world of mutual funds as I mentioned at the beginning of this blog post.
Vanguard Selected Value (VASVX)
I’m not familiar with this fund, or its management team. But familiarity is irrelevant if you own this fund as you’ll still get hit with a 6.06% capital gain distribution.
Throw in the 1.65% dividend yield and you’re coming up on nearly an 8% total taxable distribution.
Vanguard Windsor (VWNEX)
Another of the stellar line up of Wellington funds, Windsor has been around a LONG time. RIP to its long serving manager John Neff who died this year.
This fund will pay out 8.37% of its asset base as capital gains. Add in the 2.09% dividend yield, you’ll receive around 10.50% taxable distributions! YIKES!
Vanguard Windsor II (VWNAX)
Another of the Vanguard stalwarts, though this actively managed fund is not run by the Wellington team. Windsor II will pay out 8.17% in capital gains distributions come December. Add to that nearly a 2% dividend yield, and you’re looking at taxable income of $1,000 per every $10,000 you own in this fund.
Where are the Index Funds?
Notice anything missing from this list? Yes, indeed, there are no index funds paying out capital gains distributions. Why is that? Well, apparently Vanguard has a patent to avoid these yearly taxable annoyances. As if you needed another reason to invest in index funds or Vanguard…