A lot of taxes could be around the corner for these investors. Here’s why

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The good news is that surging markets have boosted investor portfolios this year.

Now for the bad news: Some of those people will be owing the taxman.

That's because mutual funds distribute capital gains to their shareholders near the end of the year. At this point, fund providers are providing investors with estimates of the gains they can expect to receive in December.

This isn't a problem for people who hold these funds in tax-deferred accounts, like individual retirement accounts or 401(k) plans.

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It is, however, an issue for investors who have these funds in taxable accounts. Those distributions are subject to the long-term capital gains rate of 0%, 15% or 20%.

Shareholders owe the tax regardless of whether they spent the distribution or reinvested it.

Strong markets this year — the S&P 500 index is up by about 11% year-to-date — have made some funds more likely to spin off considerable capital gains.

 "These distributions are concentrated in growth-oriented funds," said Christine Benz, director of personal finance at Morningstar.

Large outflows can also lead to capital gains distributions to investors at year-end. "Big shareholder redemptions force management to sell their holdings, and it makes the fund less tax-efficient," Benz said.

High turnover within a mutual fund is another culprit.

"The more investments that are sold during the year, the more likely there will be a net gain within the fund," said certified financial planner Eric Bronnenkant, CPA and head of tax at Betterment.   

Capturing those gains doesn't have to be painful, though. Financial advisors and tax professionals can strategize to mitigate the tax bite.

Gradual unwinding

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While selling out of the mutual fund altogether might be tempting, it may not be the best strategy. In that case, the investor could face a huge tax hit on the appreciation.

Instead, it might help to think about gradually unwinding that position.

"You can take that distribution and invest it somewhere else if you want to lighten your position in that fund over the long term," said Benz. "The tax consequences are the same — you still pay the taxes — but why not redeploy the gain into another fund?"

Further, individuals who've been reinvesting their distributions back into the fund might have a higher cost basis — that is, their investment in the asset — than they think.

In that case, the tax cost of selling that position may not be as high as they expect, said Benz.

"If you're reinvesting those distributions, your cost basis has been rising, so it may cost less to give your portfolio a tax-efficient makeover than you thought," she said.

Prepare for the tax bill

Mutual fund companies send investors a Form 1099-DIV with the details of the distribution in January. They'll need this form to file their 2020 income tax return come spring.

Don't wait to soften the tax hit. Here are a few steps advisors can discuss with their clients to prepare.

Consider harvesting losses: Tax-loss harvesting is a staple of year-end financial planning.

In this case, you look for investments that have lost value over the year and sell them to offset gains elsewhere in your portfolio – including those pesky capital gains distributions.

"Being able to leverage your losses helps," said Sheneya Wilson, CPA and founder of Fola Financial in New York. "Go through your total tax plan to figure out the losses that you need to harvest to offset the income."

Evaluate asset location: Capital gains distributions aren't a problem for tax-deferred accounts, like an IRA or 401(k) plan. "Re-evaluate where you're keeping this fund," said Bronnenkant. "If you have something with a lot of turnover, think, 'Am I potentially better off by keeping it in an IRA or a 401(k)?'"

Be mindful of the difference in tax treatment, too. Capital gains within a taxable account are subject to a rate of up to 20%, but you'll eventually draw down on your IRA and 401(k) and pay ordinary income taxes of up to 39.6%.

"You can invest via traditional or Roth IRAs and 401(k) plans, but all of this comes with different tax implications," said Wilson.

Revisit your holdings: Maybe it's time to consider getting out of that actively managed fund. "Are you getting enough extra return from that fund to compensate for the additional taxes you might be paying over what you'd pay with an index fund?" asked Bronnenkant.

It might be time to evaluate funds with a passive-management tilt. "The takeaway is that if you're building a tax-efficient portfolio from scratch, exchange traded funds are your friend," said Benz.

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