I just got hit with a big tax bill after a fund I own took profits on several stocks. This prompts a hypothetical question.
XYZ FUND purchased a particular stock in January for $20.00 per share. When an investor purchased that fund 6 months later the aforementioned stock was valued at $40.00 per share. On 12/31 XYZ Fund sells the stock at $50.00 per share realizing a gain of $30.00 per share. The question relates to the gain passed along to the aforementioned investor. Will he/she get saddled with a proportionate gain of $30.00/share or $10.00/share?
The capital gain “belongs” entirely to whoever owned the mutual fund at the time the gain was realized. It will also be long or short term based on the mutual fund’s holding period and not on how long the investor held the mutual fund.
I should have added that the mutual fund is required to payout all net gains at least once a year. When they pay out the distribution, the mutual fund share price will drop by the same amount (at least approximately). This will make the subsequent capital gain you have on the mutual fund smaller (or the capital loss larger), so you will recoup that gain by a subsequent loss (or at least a smaller gain).
I would assume if you bought into a fund when the value was $30, you are buying $30 shares that also already have a $10 capital gains liability. So lets say you bought into the fund giving you 100 shares of XYZ, you’ve bought $3000 of share value, but each $10 implies a capital gains tax liability of what? $2? So you own a fund where the real value is $3000 minus $200 tax liability. At the end of the year they reconcile and realize capital gains of $30 on $50, so you owe capital gains tax on $5000 minus $2000 (which assuming same, is $600 - but your fund value is now that full $5000. Your financial position is $5000 minus the $600 you paid the IRS.
Of course, depending on assorted tax issues, your capital gains may be different. Tax brackets, you can deduct other capital losses, etc.
I assume when you buy mid-year, the price reflects the capital gains liability already incurred. If you bought at $30 for only $28 for the fund, and the shares went down to $25 at year end, a share of the fund would be not $25 but $24 reflecting the XYZ share’s $1 cg liability. If they hit $20, no tax liability, $20.
The finds I’m (somewhat) familiar with roll the profits back into the fund. I do recall a year in the 90’s when the employer’s savings fund was inordinately profitable (some big buyout of shares they owned, I think) and a number of us got hit with a big tax bill. The company arranged for special withdrawals to cover the tax burden.
I’m assuming all these issues like tax liability are figured into the fund price in a general way. A $30 fund share is not worth $30 if in 6 months, even with no growth, I owe tax money on it. A fund that pretends it is will eventually lose customers to more honest funds.
I don’t think it’s as complex as you think. There is really nothing to “figure in” - mutual funds are priced to NAV (ignoring fees).
In your extreme example, suppose when you buy the fund it has a NAV of $30 including $10 of cash from just-realized capital gain. Soon after, the fund distributes the $10 capital gain to you, so the NAV from the remaining assets is now $20. If the market has not moved, it will therefore be trading ex-distribution at $20. If the market remains unchanged and you sell your holding within the same tax year, your sale generates an offsetting $10 capital loss. If the underlying market has not moved, on the whole exercise you have no profit or loss (ignoring fees) and no net taxable gain or loss:
Pay $30 to buy
Receive $10 distribution > $10 cap gain
Receive $20 proceeds from sale > $10 cap loss
So the real issue is the timing of when gains and losses hit your taxes. If you don’t sell the fund within the current tax year (and of course most people will not), then you must pay tax on the distributed gain in the current year, and you will not get the compensating tax loss until some later year when you sell your holding. So it does accelerate when you expect to pay taxes.
The point is - it doesn’t. the stocks in the fund were bought with a price of $20 at the start of the year. When you buy shares in that fund in June, the stocks it holds are worth $30. If it sold them (or didn’t), there would be $10 in capital gains. At the end of the year, the stocks it holds are worth $50, so a capital gains of $30. Whether they are sold or not, the value is “realized” and distributed, you pay tax on $30 capital gains. But, you own shares worth $50.
My point was, when you buy the fund in June, you are buying into a pile of $30 shares each with $10 of not yet realized capital gains - so the value of the fund buy-in has to be reduced by your approximate capital gains liability. Of course, by the end of the year the value and tax liability will be different from June.
In reality, the fund is churning stocks all year long and accumulating capital gains liability, which must be reconciled at the end of the year. So the value of the fund is always the value of the shares it holds, less the tax liability accumulated so far that year.