But the coal part is a possible tax bill.

Mutual fund investors with holdings in taxable accounts should be prepared for a tax impact on distributed earnings, even if they reinvest the distributions. They can offset all or part of the gains (and taxes) if they have sold positions at a loss.

People who hold mutual funds in tax-sheltered accounts such as 401 (k) or individual retirement accounts and reinvest the distributions, on the other hand, don’t have to worry. In these accounts, taxes only count when investors sell retirement assets, and those with funds in Roth qualified IRAs won’t have to pay even then.

Read: Should I use a 401 (k) or an IRA to save for retirement? A traditional account or the Roth version? Here is what you need to know

Fund companies generally estimate their distributions based on stock prices between the end of September or October. This information can be found on the website of the fund company, generally under the heading Tax information. Payments are described as percentages of assets, based on the stock prices at the time of the estimate.

Mutual funds vs ETFs

There is a second big reason beyond a good year for stocks that explains why fund companies pay capital gains globally: the tendency of investors to shift assets from mutual funds to exchange traded funds. stock market, Christopher Franz, associate director of equity strategies, told Morningstar.

In recent years, mutual fund companies have seen their assets drain on speed skates and into exchange traded funds, in large part due to lower fees and lower tax efficiency. In many cases, actively managed funds lose money to mainly passively managed ETFs.

Due to the structure of mutual funds, when investors sell their holdings in mutual funds, portfolio managers must sell assets to pay for those redemptions. Unless they can offset these gains with losses, managers record these gains and pass them on to shareholders.

ETFs are tax-efficient because the inception / redemption process mitigates some of these capital gains distributions. Rarely do ETFs pass on capital gains.

This mutual fund structure explains why investors who hold mutual funds in taxable accounts are affected by capital gains distributions even though they have not sold a single share, a result very similar to that of Grinch.

“It’s just a stark reminder that within the mutual fund structure… it basically socializes the cost of doing business,” Franz said.

Be a smarter investor. Read Need to Know every morning.

Distributions are larger than in the past

Morningstar checks capital gains distribution rates for about two dozen large fund families annually, and Franz said this year’s trend is fairly typical of last year. The company does not have general average figures on the average payout or the percentage size of the distribution because the dataset is too large, but for the record, the company notes that the distributions are now larger. than they were before. The combination of buyouts and strong stock market gains increase the volume of payments, he said.

There may be specific reasons why a fund has a high payout, such as changes in managers, strategies or indices.

In recent years, investors in growth funds have faced large distributions due to market gains, but this year the distributions are more widely distributed, Franz said, including in some strategies focused on the market. value. Value strategies have generally lagged behind the market as a whole, but this year the value has rebounded.

Two funds with big expected gains are American Century Disciplined Core Value BIGRX,
+ 0.79%
and American Century Equity Growth BEQGX,
+ 0.96%,
each with 23% of the fund’s value.

Glen Casey, global product manager at American Century, said there was no primary reason behind the distributions on the two funds, adding that the creation of capital gains is a normal result of changes in the portfolios. The company can consider the tax consequences when selling an equity interest, but this is rarely a primary factor.

“For the Disciplined Core Value fund and the Equity Growth fund, we use a structured and disciplined approach to stock selection and portfolio construction, and stocks are bought or sold based on fundamentals. Additionally, as the macroeconomic environment changes and new risks emerge, funds are actively managed to balance expected returns with long-term risks. This process will result in a rotation which can lead to capital gains as we position the portfolio on what we believe are the best opportunities for appreciation, ”he said.

Columbia Threadneedle’s payouts are examples of successful growth funds, but also highlight how passive index funds can sometimes spit out distributions. The company estimated its Columbia Large Cap Growth Opportunity NFEPX,
+ 0.68%
distribute between 21% to 25% of its fund in capital gains and its Columbia Large Cap Index NINDX,
-11.07%
between 11% and 12% of assets.

Lisa Feuerbach, spokesperson for Columbia Threadneedle, said the capital gains in Large Cap Growth Opportunity are in part due to the sale of stocks that were bought during the COVID-induced market crash in March and April 2020 .

“The higher capitalization gains for this year are due to the team remaining disciplined in valuation as many stocks hit price targets earlier than originally expected. Although we have had changes in the portfolio management team, the philosophy and process have remained consistent, ”Feuerbach said.

She also explained that the index fund will generate capital gains because the index funds, as the portfolio managers are not able to select the opportunities to harvest tax losses to minimize the distribution, being passively managed.

To minimize tracking errors and satisfy redemptions, index fund managers sell a pro rata proportion of each stock, whether the sale is a gain or a loss. “The more expensive base stocks are sold first in an attempt to minimize distribution, but after years of doing this you tend to end up with a majority of low cost base lots,” he said. she declared. The fund is primarily used in tax-eligible accounts, so most shareholders will not be affected by distributions, she added.

Among other well-known companies, several actively managed funds from Vanguard will make notable payouts this year. Vanguard Mid-Cap Growth VMGRX,
-0.33%
VMGRX will see a 25% distribution because the fund changed its sub-advisor allocation in mid-October, Franz said.

There is also an example of a rare distribution by an ETF; the Vanguard International Dividend Appreciation ETF VIGI,
+ 0.26%
changed its target benchmark earlier this year, he added.

A few growth-oriented funds from T. Rowe Price also have large distributions. They include the T. Rowe Price Global Technology PRGTX,
-1.38%
and T. Rowe Price New Horizons PRNHX,
-0.70%.

In contrast, payments from US funds appear relatively modest compared to their peers, with many in the 5-8% range. Their flagship product Growth Fund of America AGTHX,
+ 0.48%
has an estimated distribution of 6% to 8%.

Vanguard, T. Rowe and American Funds did not return requests for comment.

What to do for next year

Investors who don’t want to repeat the tax pain should think about what they want to do with their active mutual fund holdings in taxable accounts, Franz said.

The simple answer may be to sell, but it can also generate earnings. There may be strategic reasons for keeping a fund in a taxable account, so it is best to discuss this with a financial advisor.

One option open to investors is to reinvest dividends and capital gains in an ETF to reduce the problem in the future. Many fund families are starting to create ETF versions of their popular mutual funds, such as T. Rowe Price Blue Chip Growth ETF TCHP,
+ 0.54%,
an ETF version of the popular mutual fund.

Debbie Carlson is a MarketWatch columnist. Follow her on twitter @ DebbieCarlson1.

More from Debbie Carlson

As Vanguard embarks on private equity, some fans are nauseous

Can I beat the stock market with ESG investing? How to find the right fund for you

This is why this super-successful growth investor no longer owns Tesla shares