By Justin May, Portfolio Manager

If you’re reading this, it’s past Halloween, which means the “holiday season” has officially begun. The lights are going up, the music’s playing, and everyone’s diving into their favorite traditions. While Santa’s working on his list, I’m making my own and checking it twice — a list of naughty mutual funds creating surprise tax bills. Because unlike presents, the year-end “gifts” from mutual funds - capital gain distributions - are ones you don’t want to find under the tree.

What are capital gain distributions?

Mutual funds operate like individual investors throughout the year: they buy and sell stocks, and at the end of the year a tax bill is created based on the result of their trades. If they sell stock at a gain, they owe tax. If they net a loss, they use that loss against future years’ gains. Mutual funds don’t pay the tax bill they create, though – if tax is owed, they pass it on to the owners of the fund, in the form of a taxable distribution at year-end.

The type of funds we recommend typically generate little or no capital gain distributions, because they don’t trade a lot. When they do trade, they seek to minimize any tax bill. By contrast, actively managed funds – those that pick stocks rather than track an index – often pay distributions that can be 2-5% or more of their share price.

Why is this year different?

This year, active mutual fund managers face a perfect storm for larger-than-usual distributions:

1. Stocks are up and have performed exceptionally well for years, meaning most trades involve steep gains and funds have little or no prior-year losses.
2. Active managers are responding to a shifting investment landscape: tariffs, technology changes, and interest rate news. Positioning a portfolio of stocks in response to these changes requires a lot of trading.
3. Investors are shifting funds from active mutual funds to passive ETFs, so managers need to sell even more stock at a gain to fund outflows.

Based on early data, some funds are set to deliver huge tax bills. The John Hancock Equity Income fund is estimated to pay a 33+% distribution; the AB Sustainable US Thematic Portfolio is paying over 55%. Even one of the largest actively managed funds in existence, American Funds’ Growth Fund of America, is paying about 9% this year (after paying 9% last year). By my estimate, actively managed US stock funds are distributing 8-10% on average this year.

How does Old Peak help avoid these distributions?

Mutual fund companies typically give investors fair warning before capital gain distributions are paid. Generally, they provide distribution estimates in late October/early November, and distributions are paid to investors still holding the fund in mid-December. Investors can avoid distributions by selling the fund before the record date, which is a day or two before the distribution is paid.

If you’re an Old Peak client, we analyze your accounts annually for opportunities to avoid these distributions. We run a breakeven analysis which compares the gain if the position is sold to the estimated gain distribution if the position is held. For example, if you sell a mutual fund at a 30% gain, but selling avoids a 10% annual distribution, you’d pay a larger tax bill today, but you would recoup that bill over 3 years by avoiding future distributions. Typically, we recommend selling funds with a breakeven of a few years or less, though our recommendation depends on factors including your current and future tax rates. If an investor does not need the proceeds, we would often recommend reinvesting in one of our preferred funds, which we expect will have no or minimal capital gains distributions in future years.

The tax you save – whether this year or in the future – can go to presents someone will actually appreciate.