What Your Clients Should Know About Mutual Fund Distributions 

As the end of the year approaches, it’s important to discuss the potential tax consequences of mutual fund distributions—and opportunities for tax efficiency—with your clients. Be prepared to explain the tax implications of distributions, offer strategies to mitigate tax impacts, and help clients make informed investment decisions that align with their overall financial goals.

Mutual funds are required to distribute any dividends, and net realized capital gains earned over the previous 12 months. For clients holding these funds in taxable accounts, these distributions are treated as taxable income, regardless of whether they choose to reinvest the money into additional fund shares. Reminding your clients that these distributions can lead to tax liabilities—even if they haven't sold any shares—is crucial.

In contrast, the tax implications differ for clients with tax-advantaged accounts such as IRAs, 401(k)s, and other tax-deferred plans. These clients do not face immediate taxation on dividend and capital gain distributions—as long as the funds remain in the account and no withdrawals are made.

Mutual fund distributions typically fall into two categories: dividend distributions and net capital gain distributions.

Dividend distributions represent the dividend and/or interest income earned on the securities held by the fund, while net capital gain distributions reflect the gains from the sale of securities after accounting for realized losses. Gains from the sale of securities held for more than a year are taxed at lower capital gains rates than those held for a year or less, which are taxed at ordinary income rates.

As a result of the distribution, the net asset value (NAV) of a mutual fund will decrease by the amount of the distribution, which could be of concern to your clients. Help them understand that this drop doesn’t necessarily signify a loss—as long as the distribution is either taken in cash or reinvested into additional shares, which may appreciate over time.

You can suggest strategies to manage the impact of mutual fund distributions to help minimize your client’s tax exposure. One approach is to consider investing in tax-efficient equity funds, which are managed to limit capital gain distributions by keeping turnover rates low and harvesting losses where possible to offset gains.

Another strategy involves the timing of new investments in a fund. Your clients might prefer to wait until after a distribution to buy fund shares at a lower NAV, avoiding an immediate tax burden. However, you should caution them about the risk of missing potential market appreciation during the waiting period.

Clients thinking about selling fund shares to avoid the taxes on distributions should understand that if shares are sold at a gain, those gains become taxable in the year of the sale—potentially at higher ordinary income rates if the shares were held for a year or less. This possibility makes the tax-saving potential of this strategy uncertain.

In some circumstances, selling fund shares at a loss before a distribution might be advantageous, but it’s important to remind clients of the "wash sale rule," which prohibits a loss deduction if the same shares are repurchased within 30 days. This rule defers the loss, adding it to the cost basis of the new shares and can affect future tax liabilities.

Including hypothetical examples, like the following, in your discussions can improve your clients’ understanding of these strategies:

Suppose your client purchased $10,000 worth of an equity mutual fund on January 1, 2019. Over the next five years, the fund distributed $3,000, which your client reinvested and reported on their tax returns. Upon selling all shares on July 31, 2024, the investor received $19,000. Here, only $6,000 would be included as a capital gain for 2024, since they had already been taxed on the $3,000 of reinvested distributions.

While managing tax liabilities is a top priority, it's crucial that these strategies also fit within your clients' broader financial objectives and goals. Decisions driven exclusively by tax considerations could lead to costly mistakes that may reduce overall investment returns and hinder their progress toward long-term goals. In addition to tax efficiency, aim to consider factors like market performance, investment horizon, and the client's risk tolerance—and maintain this delicate balance through continual engagement with your clients.

To support their understanding of this complex topic in your year-end conversations, share our investor guide with clients: End-of-year tax considerations for capital gains: Understanding mutual fund distributions.