Capital gains in taxable accounts - Why is it that bad?

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Curiouslearner
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Capital gains in taxable accounts - Why is it that bad?

Post by Curiouslearner »

I need help to understand something that is bothering me greatly for not understanding it despite searching for it; it surely is very simple and obvious to most people in this forum but am sure I am missing a big point and hope somebody can set me straight:

What is the big deal of receiving large capital gains and dividends in a taxable account (like the recent hot topic with VG and their TDF large distributions)? I am aware of the tax implications; however, if someone receives, say $10,000 in distributions and owes $2,000 in taxes, it still leaves that person $8,000 better off to reinvest. So, why is that bad and why are funds that do not provide large distributions considered better for taxable accounts?

Thanks in advance

Cheers,
HomeStretch
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Re: Capital gains in taxable accounts - Why is it that bad?

Post by HomeStretch »

I prefer to control the amount and timing of distributions, if any, from my taxable account rather than the company/brokerage making that decision for me when they declare dividends and/or make capital gain distributions.
dbr
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Re: Capital gains in taxable accounts - Why is it that bad?

Post by dbr »

Curiouslearner wrote: Sat Jan 22, 2022 4:49 pm I need help to understand something that is bothering me greatly for not understanding it despite searching for it; it surely is very simple and obvious to most people in this forum but am sure I am missing a big point and hope somebody can set me straight:

What is the big deal of receiving large capital gains and dividends in a taxable account (like the recent hot topic with VG and their TDF large distributions)? I am aware of the tax implications; however, if someone receives, say $10,000 in distributions and owes $2,000 in taxes, it still leaves that person $8,000 better off to reinvest. So, why is that bad and why are funds that do not provide large distributions considered better for taxable accounts?

Thanks in advance

Cheers,
It's bad because you could keep the $10,000 in the value of your holding and not pay anything in tax. That means you would have $10,000 still invested and not $8000. One thing to understand is that when they distribute that $10,000, the value of your holding goes down by that amount. It isn't free money that somehow just cleverly appears. So to get back to even you have put that $10,000 back and you only have $8000 to do it with and you are out $2000 for nothing.

Eventually you might cash in that $10,000 and the idea would be that your tax rate then might be less. Your tax rate could even be zero. In any case you get to decide when to do it. There is a nuance that the $10,000 you reinvest is at a higher basis so you want to be careful to use Spec ID to keep your tax basis up to date and reduce tax costs later.
Last edited by dbr on Sat Jan 22, 2022 5:09 pm, edited 1 time in total.
02nz
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Re: Capital gains in taxable accounts - Why is it that bad?

Post by 02nz »

Curiouslearner wrote: Sat Jan 22, 2022 4:49 pm however, if someone receives, say $10,000 in distributions and owes $2,000 in taxes, it still leaves that person $8,000 better off to reinvest.
No it does not. You need to distinguish between capital gains distributions, which do not make you any richer, and actual gains realized when YOU sell shares.

Capital gains distributions are undesirable because they add to your tax bill and don't make you money. The fund makes a $10K capital gains distribution to you because it has to, as a matter of tax law, not because you actually made $10K. As with dividend distributions, the share price falls and you're no worse or better off than before ... except for owing more taxes.

Ironically, with active funds in particular capital gains distributions are often largest when they fund is doing poorly, as investors head for the exits. To meet those redemptions, the fund has to sell stocks, and the higher the gains embedded in those shares, the more the remaining investors get hosed on their taxes.
Last edited by 02nz on Sat Jan 22, 2022 5:07 pm, edited 1 time in total.
Hyperchicken
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Re: Capital gains in taxable accounts - Why is it that bad?

Post by Hyperchicken »

Capital gains and capital gain distributions are two separate things.

VG TDFs had large capital gains distributions.

What you seem to be missing is that the fund market value goes down by the amount of distribution.
someone receives, say $10,000 in distributions and owes $2,000 in taxes
The value of their investment goes down by $10,000.
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Re: Capital gains in taxable accounts - Why is it that bad?

Post by PaunchyPirate »

Remember, when a $8000 distribution is made, the value of the underlying investment also drops by $8000 in value (its share price falls). So the overall value change to the owner is $0. So now you pay taxes on $8000. If you own a fund that doesn’t make such distributions, you only face taxes when YOU sell part of it at a taxable gain.

Even if you buy something with your $8000 distribution, all you are doing is putting the money back into the market. You aren’t adding $8000 to your total holdings.
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Nate79
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Re: Capital gains in taxable accounts - Why is it that bad?

Post by Nate79 »

If your tax rate now is the same as in the future when you would sell anyway then the effect is extremely minor. Now if your tax rate is lower in retirement like many then that's the difference.
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retiredjg
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Re: Capital gains in taxable accounts - Why is it that bad?

Post by retiredjg »

Curiouslearner wrote: Sat Jan 22, 2022 4:49 pm So, why is that bad and why are funds that do not provide large distributions considered better for taxable accounts?
1. Not producing a lot of income makes a fund "tax-efficient". In other words, a tax-efficient fund does not create a lot of taxable income while it is just sitting there in the taxable account doing nothing (i.e. you didn't sell anything). A fund in a taxable account that pays out a lot of distributions that add to taxable income is not "tax-efficient".

2. In addition to this, many people like to estimate or know their expected income to stay under certain limits. Going over the limits causes them to have to spend more money or pay more taxes. Examples are staying under a limit to receive certain Affordable Care Act discounts/subsidies, or staying under a limit to avoid paying more for Medicare coverage. These are just two examples of several limits that people might plan ahead of time to stay under.

3. When a taxpayer expects a fund to pay $1,000 in taxable distributions and it turns out to be $$9,000 in taxable distributions....it can turn a good tax plan into a mess and cause them to go over limits that have financial consequences.

The problem is this happens at the end of the year when it is too late to adjust some other thing that would eliminate the problem.
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Curiouslearner
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Re: Capital gains in taxable accounts - Why is it that bad?

Post by Curiouslearner »

Folks, thanks a lot. What I missed was that the value of the fund was going down by the same amount. That’s clear now why distributions are NOT good in taxable accounts….paying to get less at the end. Not great!
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Curiouslearner
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Re: Capital gains in taxable accounts - Why is it that bad?

Post by Curiouslearner »

retiredjg wrote: Sat Jan 22, 2022 5:17 pm
Curiouslearner wrote: Sat Jan 22, 2022 4:49 pm So, why is that bad and why are funds that do not provide large distributions considered better for taxable accounts?
1. Not producing a lot of income makes a fund "tax-efficient". In other words, a tax-efficient fund does not create a lot of taxable income while it is just sitting there in the taxable account doing nothing (i.e. you didn't sell anything). A fund in a taxable account that pays out a lot of distributions that add to taxable income is not "tax-efficient".

2. In addition to this, many people like to estimate or know their expected income to stay under certain limits. Going over the limits causes them to have to spend more money or pay more taxes. Examples are staying under a limit to receive certain Affordable Care Act discounts/subsidies, or staying under a limit to avoid paying more for Medicare coverage. These are just two examples of several limits that people might plan ahead of time to stay under.

3. When a taxpayer expects a fund to pay $1,000 in taxable distributions and it turns out to be $$9,000 in taxable distributions....it can turn a good tax plan into a mess and cause them to go over limits that have financial consequences.

The problem is this happens at the end of the year when it is too late to adjust some other thing that would eliminate the problem.
A whole other level of negative effects in some circumstances. Understood. Thank you!
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Re: Capital gains in taxable accounts - Why is it that bad?

Post by quietseas »

Nate79 wrote: Sat Jan 22, 2022 5:12 pm If your tax rate now is the same as in the future when you would sell anyway then the effect is extremely minor. Now if your tax rate is lower in retirement like many then that's the difference.
Well if you leave your account to heirs and they get stepped up cost basis. In that situation no tax is owed.

No tax is owed if the appreciated securities are donated to charity either.

Those are two common situations where the current account holder never would sell.
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retiredjg
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Re: Capital gains in taxable accounts - Why is it that bad?

Post by retiredjg »

Curiouslearner wrote: Sat Jan 22, 2022 5:30 pm Folks, thanks a lot. What I missed was that the value of the fund was going down by the same amount. That’s clear now why distributions are NOT good in taxable accounts….paying to get less at the end. Not great!
I think you have understood the wrong message.

Corrected....

The value of your shares does go down when these distributions are made. However, the value of your account is the same as before...unless you take the distributions out. It is just that some of it has been taxed.
Last edited by retiredjg on Sun Jan 23, 2022 8:05 am, edited 1 time in total.
02nz
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Re: Capital gains in taxable accounts - Why is it that bad?

Post by 02nz »

retiredjg wrote: Sat Jan 22, 2022 5:48 pm The value of the shares you hold only goes down if the distribution is dividends. This does not happen if the distribution is a capital gains distribution.

However, in either case you have the exact same number of dollars in your fund.

If dividends are distributed and you reinvest them, each share is worth less but you own more shares. Nothing is lost. But you have paid tax.

If capital gains are distributed you pay tax on the gains but you still hold the same number of shares and they are worth the same number of dollars. Nothing is lost. But you have paid tax.
Maybe I'm misunderstanding you, but are you saying the NAV does not fall with a CG distribution? That would be free money, and there's definitely no free money with capital gains distributions.
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Re: Capital gains in taxable accounts - Why is it that bad?

Post by Nate79 »

retiredjg wrote: Sat Jan 22, 2022 5:48 pm
Curiouslearner wrote: Sat Jan 22, 2022 5:30 pm Folks, thanks a lot. What I missed was that the value of the fund was going down by the same amount. That’s clear now why distributions are NOT good in taxable accounts….paying to get less at the end. Not great!
I think you have understood the wrong message.

The value of the shares you hold only goes down if the distribution is dividends. This does not happen if the distribution is a capital gains distribution.

However, in either case you have the exact same number of dollars in your fund.

If dividends are distributed and you reinvest them, each share is worth less but you own more shares. Nothing is lost. But you have paid tax.

If capital gains are distributed you pay tax on the gains but you still hold the same number of shares and they are worth the same number of dollars. Nothing is lost. But you have paid tax.
No, this is completely wrong.
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retiredjg
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Re: Capital gains in taxable accounts - Why is it that bad?

Post by retiredjg »

02nz wrote: Sat Jan 22, 2022 5:53 pm
retiredjg wrote: Sat Jan 22, 2022 5:48 pm The value of the shares you hold only goes down if the distribution is dividends. This does not happen if the distribution is a capital gains distribution.

However, in either case you have the exact same number of dollars in your fund.

If dividends are distributed and you reinvest them, each share is worth less but you own more shares. Nothing is lost. But you have paid tax.

If capital gains are distributed you pay tax on the gains but you still hold the same number of shares and they are worth the same number of dollars. Nothing is lost. But you have paid tax.
Maybe I'm misunderstanding you, but are you saying the NAV does not fall with a CG distribution? That would be free money, and there's definitely no free money with capital gains distributions.
Well, maybe I'm out of my wheel house here - I don't have a taxable account so I don't see these things myself.

But my understanding is that the NAV of each share is the same after a capital gains distribution, but your basis is increased.

If I'm wrong, I'd be happy to be educated. :happy
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retiredjg
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Re: Capital gains in taxable accounts - Why is it that bad?

Post by retiredjg »

Nate79 wrote: Sat Jan 22, 2022 6:01 pm
retiredjg wrote: Sat Jan 22, 2022 5:48 pm
Curiouslearner wrote: Sat Jan 22, 2022 5:30 pm Folks, thanks a lot. What I missed was that the value of the fund was going down by the same amount. That’s clear now why distributions are NOT good in taxable accounts….paying to get less at the end. Not great!
I think you have understood the wrong message.

The value of the shares you hold only goes down if the distribution is dividends. This does not happen if the distribution is a capital gains distribution.

However, in either case you have the exact same number of dollars in your fund.

If dividends are distributed and you reinvest them, each share is worth less but you own more shares. Nothing is lost. But you have paid tax.

If capital gains are distributed you pay tax on the gains but you still hold the same number of shares and they are worth the same number of dollars. Nothing is lost. But you have paid tax.
No, this is completely wrong.
OK. Educate me please.
02nz
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Re: Capital gains in taxable accounts - Why is it that bad?

Post by 02nz »

retiredjg wrote: Sat Jan 22, 2022 6:02 pm
02nz wrote: Sat Jan 22, 2022 5:53 pm
retiredjg wrote: Sat Jan 22, 2022 5:48 pm The value of the shares you hold only goes down if the distribution is dividends. This does not happen if the distribution is a capital gains distribution.

However, in either case you have the exact same number of dollars in your fund.

If dividends are distributed and you reinvest them, each share is worth less but you own more shares. Nothing is lost. But you have paid tax.

If capital gains are distributed you pay tax on the gains but you still hold the same number of shares and they are worth the same number of dollars. Nothing is lost. But you have paid tax.
Maybe I'm misunderstanding you, but are you saying the NAV does not fall with a CG distribution? That would be free money, and there's definitely no free money with capital gains distributions.
Well, maybe I'm out of my wheel house here - I don't have a taxable account so I don't see these things myself.

But my understanding is that the NAV of each share is the same after a capital gains distribution, but your basis is increased.

If I'm wrong, I'd be happy to be educated. :happy
I don't think that's possible. The CG distribution would also be made to tax-advantaged accounts, and if the NAV didn't fall after the CG distribution, you'd have free money, and we know there's no free money. :happy
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Re: Capital gains in taxable accounts - Why is it that bad?

Post by Nate79 »

retiredjg wrote: Sat Jan 22, 2022 6:03 pm
Nate79 wrote: Sat Jan 22, 2022 6:01 pm
retiredjg wrote: Sat Jan 22, 2022 5:48 pm
Curiouslearner wrote: Sat Jan 22, 2022 5:30 pm Folks, thanks a lot. What I missed was that the value of the fund was going down by the same amount. That’s clear now why distributions are NOT good in taxable accounts….paying to get less at the end. Not great!
I think you have understood the wrong message.

The value of the shares you hold only goes down if the distribution is dividends. This does not happen if the distribution is a capital gains distribution.

However, in either case you have the exact same number of dollars in your fund.

If dividends are distributed and you reinvest them, each share is worth less but you own more shares. Nothing is lost. But you have paid tax.

If capital gains are distributed you pay tax on the gains but you still hold the same number of shares and they are worth the same number of dollars. Nothing is lost. But you have paid tax.
No, this is completely wrong.
OK. Educate me please.
The price of a mutual fund goes down with both types of distributions, dividends and capital gains. Both are cash distributions out of the NAV.
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Curiouslearner
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Re: Capital gains in taxable accounts - Why is it that bad?

Post by Curiouslearner »

I can see that the value of the VG TDFunds did indeed drop in value on Dec. 28th because of the large CG distributions.

https://www.personalfinanceclub.com/van ... mber-2021/

No impact for people with those funds in tax-deferred accounts but with the above mentioned consequences for people keeping them in taxable accounts.

I’ve learnt several useful things today with your help. Thanks a lot!
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Re: Capital gains in taxable accounts - Why is it that bad?

Post by coffeeblack »

The problem is this happens at the end of the year when it is too late to adjust some other thing that would eliminate the problem.
[/quote]

It seems one can do some adjustments the next year due to the extra income gained from the distributions in the previous year to try to offset some of the mess. It's still guesswork and can change their withdrawal rate involuntarily.

It's just that once you have maxed out your retirement accounts you have no choice but to invest in taxable if you want to keep investing.
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Re: Capital gains in taxable accounts - Why is it that bad?

Post by vxdx »

My understanding is that fundamentally it’s either paying the taxes now at your current rate or later at a rate you may have more control over.

If you pay taxes now and the gains are reinvested, your cost basis also increases and your future taxes are reduced.

If the tax rates now or later are the same there is no difference in the amount you keep.
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Re: Capital gains in taxable accounts - Why is it that bad?

Post by 02nz »

vxdx wrote: Sat Jan 22, 2022 6:57 pm My understanding is that fundamentally it’s either paying the taxes now at your current rate or later at a rate you may have more control over.

If you pay taxes now and the gains are reinvested, your cost basis also increases and your future taxes are reduced.

If the tax rates now or later are the same there is no difference in the amount you keep.
You're talking about actual gains though. The OP's question was about capital gains distributions, which you want to avoid if possible, because they create a tax liability without making any money. Avoiding capital gains distributions is one of Vanguard's big advantages in their stock mutual funds that have an ETF class, as these mutual funds do not generally distribute capital gains.

Also: "If the tax rates now or later are the same there is no difference in the amount you keep" is true when it comes to Roth vs traditional, but it's definitely incorrect with taxable accounts. The money to pay the capital gains taxes has to come from somewhere, and that money is not available to be invested, so you lose out on compounding when compared with a tax-advantaged account. This is called "tax drag" - the tax cost of investments in a non-tax-advantaged account that is incurred even when the investor has not chosen to sell any shares.
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Re: Capital gains in taxable accounts - Why is it that bad?

Post by vxdx »

I’ve always been unsure about this for taxable so your response got me to run some numbers, and thank you for correcting me here.

Suppose I have 1000 and 10% gains distribution on which I pay 10% tax every year and reinvest the gains minus tax.

Year 1, 1100-.1*100=1090
Year 2 1199-.1*109=1188.1
Year 3 1306.91-.1*118.81=1295.029

Alternatively it grows at 10% but is taxed on gains at the end
Year 1 1100
Year 2 1210
Year 3 1331-.1*331=1297.9
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Re: Capital gains in taxable accounts - Why is it that bad?

Post by ivgrivchuck »

The main reason is that for people with big portfolios, it's very different between:
A) Receiving $1M capital gains in 1 year
B) Receiving $100k capital gains over 10 years

As the income tax (and state tax) is progressive.
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Re: Capital gains in taxable accounts - Why is it that bad?

Post by rossington »

retiredjg wrote: Sat Jan 22, 2022 5:48 pm
Curiouslearner wrote: Sat Jan 22, 2022 5:30 pm Folks, thanks a lot. What I missed was that the value of the fund was going down by the same amount. That’s clear now why distributions are NOT good in taxable accounts….paying to get less at the end. Not great!
I think you have understood the wrong message.

The value of the shares you hold only goes down if the distribution is dividends. This does not happen if the distribution is a capital gains distribution.
Cap. Gains distributions do reduce the NAV:

"Capital Gains Distributions and Net Asset Value
As is the case with common stocks, the distribution of capital gains and dividends decreases the net asset value (NAV) of the fund by the amount distributed. "

https://www.investopedia.com/terms/c/ca ... bution.asp

:beer
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retiredjg
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Re: Capital gains in taxable accounts - Why is it that bad?

Post by retiredjg »

retiredjg wrote: Sat Jan 22, 2022 5:48 pm
Curiouslearner wrote: Sat Jan 22, 2022 5:30 pm Folks, thanks a lot. What I missed was that the value of the fund was going down by the same amount. That’s clear now why distributions are NOT good in taxable accounts….paying to get less at the end. Not great!
I think you have understood the wrong message.
Many thanks to those who pointed out my error regarding capital gains distributions. I have corrected my post.

The message to Curiouslearner is the same though...you have not lost anything when these distributions occur. You still have the same amount of money in the account. It's just that some of it has been taxed.
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Re: Capital gains in taxable accounts - Why is it that bad?

Post by anon_investor »

retiredjg wrote: Sun Jan 23, 2022 7:59 am
retiredjg wrote: Sat Jan 22, 2022 5:48 pm
Curiouslearner wrote: Sat Jan 22, 2022 5:30 pm Folks, thanks a lot. What I missed was that the value of the fund was going down by the same amount. That’s clear now why distributions are NOT good in taxable accounts….paying to get less at the end. Not great!
I think you have understood the wrong message.
Many thanks to those who pointed out my error regarding capital gains distributions. I have corrected my post.

The message to Curiouslearner is the same though...you have not lost anything when these distributions occur. You still have the same amount of money in the account. It's just that some of it has been taxed.
But the tax is a loss of compounding grown opportunity, especially if there are capital gains distributions annually. That is why deferral of taxes is beneficial. What you would be taxed gets to stay invested and grow. Also taxes may never need to pay if the investment is never sold and the owner passes, the heirs receive a step up in cost basis.
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Re: Capital gains in taxable accounts - Why is it that bad?

Post by Nowizard »

The key to any statement suggesting an absolute with investing is to recognize that all of those statements reflect a specific point-of-view, not fact in many cases. For example, "Past results do not guarantee future ones" is actually an absurd statement since we all predict that future results will be positive or we would not invest at all. Capital gains in taxable accounts are "bad" for those who are attempting to limit AGI for purposes of not paying any (or more) IRMAA in retirement, as a simple example, but may be inconsequential for others. "Bad" is a reaction, but personal circumstances are a better determiner of action.

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Re: Capital gains in taxable accounts - Why is it that bad?

Post by retiredjg »

anon_investor wrote: Sun Jan 23, 2022 8:28 am
retiredjg wrote: Sun Jan 23, 2022 7:59 am
retiredjg wrote: Sat Jan 22, 2022 5:48 pm
Curiouslearner wrote: Sat Jan 22, 2022 5:30 pm Folks, thanks a lot. What I missed was that the value of the fund was going down by the same amount. That’s clear now why distributions are NOT good in taxable accounts….paying to get less at the end. Not great!
I think you have understood the wrong message.
Many thanks to those who pointed out my error regarding capital gains distributions. I have corrected my post.

The message to Curiouslearner is the same though...you have not lost anything when these distributions occur. You still have the same amount of money in the account. It's just that some of it has been taxed.
But the tax is a loss of compounding grown opportunity, especially if there are capital gains distributions annually. That is why deferral of taxes is beneficial. What you would be taxed gets to stay invested and grow. Also taxes may never need to pay if the investment is never sold and the owner passes, the heirs receive a step up in cost basis.
Agreed. The loss is the tax that has to be paid which is why people don't want capital gains distributions.

Perhaps I have read curiouslearner's post incorrectly, but I took the post to mean that the loss of value of the fund is where the loss occurs. It's not. The value of the fund stays the same unless the distributions are removed. It's the tax paid that is the loss.
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Re: Capital gains in taxable accounts - Why is it that bad?

Post by dbr »

retiredjg wrote: Sun Jan 23, 2022 9:07 am
anon_investor wrote: Sun Jan 23, 2022 8:28 am
retiredjg wrote: Sun Jan 23, 2022 7:59 am
retiredjg wrote: Sat Jan 22, 2022 5:48 pm
Curiouslearner wrote: Sat Jan 22, 2022 5:30 pm Folks, thanks a lot. What I missed was that the value of the fund was going down by the same amount. That’s clear now why distributions are NOT good in taxable accounts….paying to get less at the end. Not great!
I think you have understood the wrong message.
Many thanks to those who pointed out my error regarding capital gains distributions. I have corrected my post.

The message to Curiouslearner is the same though...you have not lost anything when these distributions occur. You still have the same amount of money in the account. It's just that some of it has been taxed.
But the tax is a loss of compounding grown opportunity, especially if there are capital gains distributions annually. That is why deferral of taxes is beneficial. What you would be taxed gets to stay invested and grow. Also taxes may never need to pay if the investment is never sold and the owner passes, the heirs receive a step up in cost basis.
Agreed. The loss is the tax that has to be paid which is why people don't want capital gains distributions.

Perhaps I have read curiouslearner's post incorrectly, but I took the post to mean that the loss of value of the fund is where the loss occurs. It's not. The value of the fund stays the same unless the distributions are removed. It's the tax paid that is the loss.
That is correct. As long as the investor is doing the correct accounting which includes that the distribution is reinvested in full, the loss is the tax paid. I believe the OP imagined that the distribution could be withdrawn without decreasing the value of the remaining holding, aka the free money fallacy. I would also be happy paying tax on free money.
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Re: Capital gains in taxable accounts - Why is it that bad?

Post by Jaylat »

At least to me, I think we’re downplaying just how insidious this capital gain distribution is. In the first example, the OP has $10,000 after tax – he has already paid Federal, state and local taxes on that money. If he puts it in a bank account he will never pay tax on that $10,000 in principal again.

The truly insidious thing here is that by putting it into a managed fund, his $10,000 after tax money is magically turned into (1) a capital gain of (say) $2,000 on while he will have to pay Federal, state and local taxes AGAIN, and (2) a loss of value of $2,000 in the account.

Yes, he could sell the shares at a loss to theoretically offset the capital gain, but Vanguard helpfully made the distributions at the end of December so it’s too late for that.

To me this is a land mine that should be highlighted to unsuspecting investors (like myself). If you're in a high tax state it's a nightmare waiting to happen.
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Re: Capital gains in taxable accounts - Why is it that bad?

Post by Nate79 »

Jaylat wrote: Sun Jan 23, 2022 11:43 am At least to me, I think we’re downplaying just how insidious this capital gain distribution is. In the first example, the OP has $10,000 after tax – he has already paid Federal, state and local taxes on that money. If he puts it in a bank account he will never pay tax on that $10,000 in principal again.

The truly insidious thing here is that by putting it into a managed fund, his $10,000 after tax money is magically turned into (1) a capital gain of (say) $2,000 on while he will have to pay Federal, state and local taxes AGAIN, and (2) a loss of value of $2,000 in the account.

Yes, he could sell the shares at a loss to theoretically offset the capital gain, but Vanguard helpfully made the distributions at the end of December so it’s too late for that.

To me this is a land mine that should be highlighted to unsuspecting investors (like myself). If you're in a high tax state it's a nightmare waiting to happen.
If someone has $10k in the fund that distributed $2k of capital gains the account will have ... wait for it, wait for it... $10k. The same amount. The only difference is they will have to pay tax on the $2k. If that $2k is reinvested (to make this an apples to apples discussion) their cost basis in the $10k is reduced by the $2k that has now been taxed. Thus they are paying taxes on something that was going to be taxed in the future. The difference is:
1) the money they paid in taxes is not growing in a savings account so they lose out on the gains if those taxes had been invested (I'm not sure what the risk equivalent rate of return should be on this though)
2) if those funds were to be sold in the future for a lower tax rate (of course tax rates can go up in the future too so this isn't a guarantee)
sonosoldi3112
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Re: Capital gains in taxable accounts - Why is it that bad?

Post by sonosoldi3112 »

Would I be correct in thinking that these capital gains and dividend distributions ( if all fall under long term and tax code remains the same) are good in the scenario where one is living off a portfolio in retirement and need income in excess of the distributions ... ie would be selling shares anyway ....in such circumstances would it not be a negative as such .... you are in the spending phase of your portfolio.

Thanks all
Jaylat
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Re: Capital gains in taxable accounts - Why is it that bad?

Post by Jaylat »

Nate79 wrote: Sun Jan 23, 2022 12:09 pm
Jaylat wrote: Sun Jan 23, 2022 11:43 am At least to me, I think we’re downplaying just how insidious this capital gain distribution is. In the first example, the OP has $10,000 after tax – he has already paid Federal, state and local taxes on that money. If he puts it in a bank account he will never pay tax on that $10,000 in principal again.

The truly insidious thing here is that by putting it into a managed fund, his $10,000 after tax money is magically turned into (1) a capital gain of (say) $2,000 on while he will have to pay Federal, state and local taxes AGAIN, and (2) a loss of value of $2,000 in the account.

Yes, he could sell the shares at a loss to theoretically offset the capital gain, but Vanguard helpfully made the distributions at the end of December so it’s too late for that.

To me this is a land mine that should be highlighted to unsuspecting investors (like myself). If you're in a high tax state it's a nightmare waiting to happen.
If someone has $10k in the fund that distributed $2k of capital gains the account will have ... wait for it, wait for it... $10k. The same amount. The only difference is they will have to pay tax on the $2k. If that $2k is reinvested (to make this an apples to apples discussion) their cost basis in the $10k is reduced by the $2k that has now been taxed. Thus they are paying taxes on something that was going to be taxed in the future. The difference is:
1) the money they paid in taxes is not growing in a savings account so they lose out on the gains if those taxes had been invested (I'm not sure what the risk equivalent rate of return should be on this though)
2) if those funds were to be sold in the future for a lower tax rate (of course tax rates can go up in the future too so this isn't a guarantee)
"The only difference is they will have to pay tax on the $2k" In the other thread the OP was talking about a $1mm taxable distribution. That's a HUGE difference!

Again, I think you're understating this. The $2k distribution is taxable income, and the taxes paid on it are a real loss to the investor. It's a tax liability created out of thin air. So unless you can offset it immediately, it's a real loss to the investor.

It doesn't matter how you reinvest it, a loss is a loss.
Morik
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Re: Capital gains in taxable accounts - Why is it that bad?

Post by Morik »

sonosoldi3112 wrote: Sun Jan 23, 2022 12:27 pm Would I be correct in thinking that these capital gains and dividend distributions ( if all fall under long term and tax code remains the same) are good in the scenario where one is living off a portfolio in retirement and need income in excess of the distributions ... ie would be selling shares anyway ....in such circumstances would it not be a negative as such .... you are in the spending phase of your portfolio.

Thanks all
If you need to pull at least that much money anyway, it isn't a negative. But it also isn't beneficial. If there was no distribution, you would just sell whatever amount you need to pull out. If you don't need at least that amount pulled out, it is negative.
dbr
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Re: Capital gains in taxable accounts - Why is it that bad?

Post by dbr »

sonosoldi3112 wrote: Sun Jan 23, 2022 12:27 pm Would I be correct in thinking that these capital gains and dividend distributions ( if all fall under long term and tax code remains the same) are good in the scenario where one is living off a portfolio in retirement and need income in excess of the distributions ... ie would be selling shares anyway ....in such circumstances would it not be a negative as such .... you are in the spending phase of your portfolio.

Thanks all
No, if you take the distributions then you are paying at long term or qualified dividend tax rate on your entire income. If you could sell shares part of the proceeds would be already taxed basis and not all your income would be taxed. In addition you can examine your basis by tax lot and sell those with the least gain when your tax situation for that year is not favorable and those with the most gain when you can do that at lowest cost. The best thing is to have no distributions. If you are forced to take distributions, then logically you would go ahead and spend that rather than reinvesting and then adding even more tax cost by selling shares. If the shares you sell are the shares you just bought with the distribution the tax cost would be small, though.

I recently "sold" some stocks with a large gain but no tax cost by giving them to someone who had no income last year who was able to take the gain at a 0% tax cost. That was in preference to me selling the stock and giving them the after tax money.
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Re: Capital gains in taxable accounts - Why is it that bad?

Post by FIdream2 »

Hyperchicken wrote: Sat Jan 22, 2022 5:07 pm Capital gains and capital gain distributions are two separate things.

VG TDFs had large capital gains distributions.

What you seem to be missing is that the fund market value goes down by the amount of distribution.
someone receives, say $10,000 in distributions and owes $2,000 in taxes
The value of their investment goes down by $10,000.
I think I understand why the value of the investment goes down, but do you mind elaborating/explaining why? Want to make sure i’m understanding it correctly

Thanks!
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Re: Capital gains in taxable accounts - Why is it that bad?

Post by Nate79 »

Jaylat wrote: Sun Jan 23, 2022 12:38 pm
Nate79 wrote: Sun Jan 23, 2022 12:09 pm
Jaylat wrote: Sun Jan 23, 2022 11:43 am At least to me, I think we’re downplaying just how insidious this capital gain distribution is. In the first example, the OP has $10,000 after tax – he has already paid Federal, state and local taxes on that money. If he puts it in a bank account he will never pay tax on that $10,000 in principal again.

The truly insidious thing here is that by putting it into a managed fund, his $10,000 after tax money is magically turned into (1) a capital gain of (say) $2,000 on while he will have to pay Federal, state and local taxes AGAIN, and (2) a loss of value of $2,000 in the account.

Yes, he could sell the shares at a loss to theoretically offset the capital gain, but Vanguard helpfully made the distributions at the end of December so it’s too late for that.

To me this is a land mine that should be highlighted to unsuspecting investors (like myself). If you're in a high tax state it's a nightmare waiting to happen.
If someone has $10k in the fund that distributed $2k of capital gains the account will have ... wait for it, wait for it... $10k. The same amount. The only difference is they will have to pay tax on the $2k. If that $2k is reinvested (to make this an apples to apples discussion) their cost basis in the $10k is reduced by the $2k that has now been taxed. Thus they are paying taxes on something that was going to be taxed in the future. The difference is:
1) the money they paid in taxes is not growing in a savings account so they lose out on the gains if those taxes had been invested (I'm not sure what the risk equivalent rate of return should be on this though)
2) if those funds were to be sold in the future for a lower tax rate (of course tax rates can go up in the future too so this isn't a guarantee)
"The only difference is they will have to pay tax on the $2k" In the other thread the OP was talking about a $1mm taxable distribution. That's a HUGE difference!

Again, I think you're understating this. The $2k distribution is taxable income, and the taxes paid on it are a real loss to the investor. It's a tax liability created out of thin air. So unless you can offset it immediately, it's a real loss to the investor.

It doesn't matter how you reinvest it, a loss is a loss.
No, I disagree. The taxes on the $2k is not lost. The taxes on the $2k distribution was going to be paid now or in the future once the shares are sold since that $2k distribution lowered the cost basis by $2k (let's say in retirement). Its a wash.
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Re: Capital gains in taxable accounts - Why is it that bad?

Post by nolesrule »

Nate79 wrote: Sun Jan 23, 2022 1:35 pm
Jaylat wrote: Sun Jan 23, 2022 12:38 pm
Nate79 wrote: Sun Jan 23, 2022 12:09 pm
Jaylat wrote: Sun Jan 23, 2022 11:43 am At least to me, I think we’re downplaying just how insidious this capital gain distribution is. In the first example, the OP has $10,000 after tax – he has already paid Federal, state and local taxes on that money. If he puts it in a bank account he will never pay tax on that $10,000 in principal again.

The truly insidious thing here is that by putting it into a managed fund, his $10,000 after tax money is magically turned into (1) a capital gain of (say) $2,000 on while he will have to pay Federal, state and local taxes AGAIN, and (2) a loss of value of $2,000 in the account.

Yes, he could sell the shares at a loss to theoretically offset the capital gain, but Vanguard helpfully made the distributions at the end of December so it’s too late for that.

To me this is a land mine that should be highlighted to unsuspecting investors (like myself). If you're in a high tax state it's a nightmare waiting to happen.
If someone has $10k in the fund that distributed $2k of capital gains the account will have ... wait for it, wait for it... $10k. The same amount. The only difference is they will have to pay tax on the $2k. If that $2k is reinvested (to make this an apples to apples discussion) their cost basis in the $10k is reduced by the $2k that has now been taxed. Thus they are paying taxes on something that was going to be taxed in the future. The difference is:
1) the money they paid in taxes is not growing in a savings account so they lose out on the gains if those taxes had been invested (I'm not sure what the risk equivalent rate of return should be on this though)
2) if those funds were to be sold in the future for a lower tax rate (of course tax rates can go up in the future too so this isn't a guarantee)
"The only difference is they will have to pay tax on the $2k" In the other thread the OP was talking about a $1mm taxable distribution. That's a HUGE difference!

Again, I think you're understating this. The $2k distribution is taxable income, and the taxes paid on it are a real loss to the investor. It's a tax liability created out of thin air. So unless you can offset it immediately, it's a real loss to the investor.

It doesn't matter how you reinvest it, a loss is a loss.
No, I disagree. The taxes on the $2k is not lost. The taxes on the $2k distribution was going to be paid now or in the future once the shares are sold since that $2k distribution lowered the cost basis by $2k (let's say in retirement). Its a wash.
It's only a wash if the tax rate remains unchanged between now and the future.
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Re: Capital gains in taxable accounts - Why is it that bad?

Post by dbr »

nolesrule wrote: Sun Jan 23, 2022 1:52 pm

It's only a wash if the tax rate remains unchanged between now and the future.
Not only that it is an issue if the shares even are sold by the original investor. Other options are gifting the shares to someone who is not taxed or taxed very little or letting heirs take basis step up.
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Re: Capital gains in taxable accounts - Why is it that bad?

Post by Jaylat »

Nate79 wrote: Sun Jan 23, 2022 1:35 pm No, I disagree. The taxes on the $2k is not lost. The taxes on the $2k distribution was going to be paid now or in the future once the shares are sold since that $2k distribution lowered the cost basis by $2k (let's say in retirement). Its a wash.
If you invested in any other kind of fund without a capital gain distribution, those taxes would never have to be paid - ever. You had already paid taxes on the funds used to invest.

In practice, you might be able to offset them by selling the remaining shares at a loss, assuming you're in the same tax bracket. But why put yourself through all that hassle? Why incur a tax liability you don't have to?

At best, you're out the time cost of the money used to pay taxes, and making an interest free loan to the IRS. Again the OP in the other thread was hit with a $1mm tax liability. His tax hit would be at the top marginal tax rate - good luck getting that back.
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Re: Capital gains in taxable accounts - Why is it that bad?

Post by rossington »

Nate79 wrote: Sun Jan 23, 2022 12:09 pm
If that $2k is reinvested (to make this an apples to apples discussion) their cost basis in the $10k is reduced by the $2k that has now been taxed.
It is only reduced by 2k on the distribution date, but if it is subsequently reinvested then the cost basis is increased by 2k on the reinvestment date.
"Success is going from failure to failure without loss of enthusiasm." Winston Churchill.
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Re: Capital gains in taxable accounts - Why is it that bad?

Post by Nate79 »

nolesrule wrote: Sun Jan 23, 2022 1:52 pm
Nate79 wrote: Sun Jan 23, 2022 1:35 pm
Jaylat wrote: Sun Jan 23, 2022 12:38 pm
Nate79 wrote: Sun Jan 23, 2022 12:09 pm
Jaylat wrote: Sun Jan 23, 2022 11:43 am At least to me, I think we’re downplaying just how insidious this capital gain distribution is. In the first example, the OP has $10,000 after tax – he has already paid Federal, state and local taxes on that money. If he puts it in a bank account he will never pay tax on that $10,000 in principal again.

The truly insidious thing here is that by putting it into a managed fund, his $10,000 after tax money is magically turned into (1) a capital gain of (say) $2,000 on while he will have to pay Federal, state and local taxes AGAIN, and (2) a loss of value of $2,000 in the account.

Yes, he could sell the shares at a loss to theoretically offset the capital gain, but Vanguard helpfully made the distributions at the end of December so it’s too late for that.

To me this is a land mine that should be highlighted to unsuspecting investors (like myself). If you're in a high tax state it's a nightmare waiting to happen.
If someone has $10k in the fund that distributed $2k of capital gains the account will have ... wait for it, wait for it... $10k. The same amount. The only difference is they will have to pay tax on the $2k. If that $2k is reinvested (to make this an apples to apples discussion) their cost basis in the $10k is reduced by the $2k that has now been taxed. Thus they are paying taxes on something that was going to be taxed in the future. The difference is:
1) the money they paid in taxes is not growing in a savings account so they lose out on the gains if those taxes had been invested (I'm not sure what the risk equivalent rate of return should be on this though)
2) if those funds were to be sold in the future for a lower tax rate (of course tax rates can go up in the future too so this isn't a guarantee)
"The only difference is they will have to pay tax on the $2k" In the other thread the OP was talking about a $1mm taxable distribution. That's a HUGE difference!

Again, I think you're understating this. The $2k distribution is taxable income, and the taxes paid on it are a real loss to the investor. It's a tax liability created out of thin air. So unless you can offset it immediately, it's a real loss to the investor.

It doesn't matter how you reinvest it, a loss is a loss.
No, I disagree. The taxes on the $2k is not lost. The taxes on the $2k distribution was going to be paid now or in the future once the shares are sold since that $2k distribution lowered the cost basis by $2k (let's say in retirement). Its a wash.
It's only a wash if the tax rate remains unchanged between now and the future.
Yes, that was my point #2 above. Of course nothing says tax rates are lower in the future. They could go up as they were in the past.
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Re: Capital gains in taxable accounts - Why is it that bad?

Post by jebmke »

sonosoldi3112 wrote: Sun Jan 23, 2022 12:27 pm Would I be correct in thinking that these capital gains and dividend distributions ( if all fall under long term and tax code remains the same) are good in the scenario where one is living off a portfolio in retirement and need income in excess of the distributions ... ie would be selling shares anyway ....in such circumstances would it not be a negative as such .... you are in the spending phase of your portfolio.

Thanks all
Depends. I lived off portfolio after retirement but paid no taxes on gains taken because I had aggressively harvested losses during the 2008-09 down-tick. That got me to my pension years and when SS starts next year -- ~ 90% of our spending may be covered already so I may never take gains again in equity.
Don't trust me, look it up. https://www.irs.gov/forms-instructions-and-publications
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Re: Capital gains in taxable accounts - Why is it that bad?

Post by RickyAZ »

nolesrule wrote: Sun Jan 23, 2022 1:52 pm
Nate79 wrote: Sun Jan 23, 2022 1:35 pm
Jaylat wrote: Sun Jan 23, 2022 12:38 pm
Nate79 wrote: Sun Jan 23, 2022 12:09 pm
Jaylat wrote: Sun Jan 23, 2022 11:43 am At least to me, I think we’re downplaying just how insidious this capital gain distribution is. In the first example, the OP has $10,000 after tax – he has already paid Federal, state and local taxes on that money. If he puts it in a bank account he will never pay tax on that $10,000 in principal again.

The truly insidious thing here is that by putting it into a managed fund, his $10,000 after tax money is magically turned into (1) a capital gain of (say) $2,000 on while he will have to pay Federal, state and local taxes AGAIN, and (2) a loss of value of $2,000 in the account.

Yes, he could sell the shares at a loss to theoretically offset the capital gain, but Vanguard helpfully made the distributions at the end of December so it’s too late for that.

To me this is a land mine that should be highlighted to unsuspecting investors (like myself). If you're in a high tax state it's a nightmare waiting to happen.
If someone has $10k in the fund that distributed $2k of capital gains the account will have ... wait for it, wait for it... $10k. The same amount. The only difference is they will have to pay tax on the $2k. If that $2k is reinvested (to make this an apples to apples discussion) their cost basis in the $10k is reduced by the $2k that has now been taxed. Thus they are paying taxes on something that was going to be taxed in the future. The difference is:
1) the money they paid in taxes is not growing in a savings account so they lose out on the gains if those taxes had been invested (I'm not sure what the risk equivalent rate of return should be on this though)
2) if those funds were to be sold in the future for a lower tax rate (of course tax rates can go up in the future too so this isn't a guarantee)
"The only difference is they will have to pay tax on the $2k" In the other thread the OP was talking about a $1mm taxable distribution. That's a HUGE difference!

Again, I think you're understating this. The $2k distribution is taxable income, and the taxes paid on it are a real loss to the investor. It's a tax liability created out of thin air. So unless you can offset it immediately, it's a real loss to the investor.

It doesn't matter how you reinvest it, a loss is a loss.
No, I disagree. The taxes on the $2k is not lost. The taxes on the $2k distribution was going to be paid now or in the future once the shares are sold since that $2k distribution lowered the cost basis by $2k (let's say in retirement). Its a wash.
It's only a wash if the tax rate remains unchanged between now and the future.
The 2000$ is not a loss. If you’re now left with a fund at a value of 10k the fund has lost money since the basis for the 2k lot was reset.

The taxable account would be paying capital gain rates not, say 22% like a retirement withdrawal if you’re in that bracket. Indeed, if you’re paying 22% just to save in your Roth for capital gains distributions you’d be better off leaving in taxable (this is not the same as appreciation, of course).

Meanwhile you’re paying 0$ if you’re in the 12% bracket whereas the retirement account withdrawal is paying 12% on the same distributions (if made up of capital gains)

Tax must be paid at some point, it’s just a matter of when and at what rate.

The problem with mutual funds in taxable is that the timing and amount of capital gains distributions can be unfortunate in their timing and amount and can upset a careful tax plan.

Cheers
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Re: Capital gains in taxable accounts - Why is it that bad?

Post by Nate79 »

rossington wrote: Sun Jan 23, 2022 2:18 pm
Nate79 wrote: Sun Jan 23, 2022 12:09 pm
If that $2k is reinvested (to make this an apples to apples discussion) their cost basis in the $10k is reduced by the $2k that has now been taxed.
It is only reduced by 2k on the distribution date, but if it is subsequently reinvested then the cost basis is increased by 2k on the reinvestment date.
No, I dont know what you are trying to say here.
Let's write the example out in more detail.
Suppose I have 10,000 shares at a share price of $1 (for simplicity sake suppose they have a basis of $0.50 but it has no impact on the math). They distribute $2,000 of capital gains. I now have 10,000 shares at a price of $0.80 and $2,000 dollars cash (which needs taxes paid on it). On that day of distribution if set to reinvest I will have:
10,000 shares of original basis ($0.5) worth $8,000
2,500 shares of basis of $0.80 worth $2,000

Now suppose the stock gains 10% in the next year and I sell all. New share price at sale is $0.88.
Sales proceeds will be:
10,000*0.88=$8,800 and a gain of $3,800
2,500*0.88=$2,200 and a gain of $200.
So I got $11,000 from the sale and gain of $4,000 to pay taxes on.

If the distribution hadn't happened I would have had:
10,000 shares*$1.10 (10% rise of share price) =$11,000 and a gain of $6,000 to pay taxes on.

If in the end the tax rates are the same then the amount of taxes will be the same (or if taxes rates are different they will be different). What is different is the taxes paid on the $2,000 distribution can't be growing in your savings account over time (tax drag).

The reinvested shares that were reinvested at the new higher price reset their basis to that date and essentially from that date they were all taxes paid.
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Re: Capital gains in taxable accounts - Why is it that bad?

Post by vxdx »

This discussion has made me question a belief I had, and I’d appreciate someone’s insight.

If I buy into a fund at 1000 and immediately am hit with a capital gains distribution, I would pay tax on that distribution even though it’s not a capital gain to me, right? Essentially I’m taxed on the funds gains from before I invested.

Is there no way to justify in my own taxes that I did not personally realize any gains?

Would this be true for the fund in perpetuity? I.e. if this fund has total gains since inception of 99%, but has distributed none of it, is it possible for almost all of the value to be distributed at some point in the future as capital gains, or is there a limit?
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Re: Capital gains in taxable accounts - Why is it that bad?

Post by jebmke »

vxdx wrote: Sun Jan 23, 2022 2:46 pm This discussion has made me question a belief I had, and I’d appreciate someone’s insight.

If I buy into a fund at 1000 and immediately am hit with a capital gains distribution, I would pay tax on that distribution even though it’s not a capital gain to me, right? Essentially I’m taxed on the funds gains from before I invested.depends on other aspects of your return, but it could be that you would be taxed, assuming this isn't in a sheltered account

Is there no way to justify in my own taxes that I did not personally realize any gains?Nope

Would this be true for the fund in perpetuity? I.e. if this fund has total gains since inception of 99%, but has distributed none of it, is it possible for almost all of the value to be distributed at some point in the future as capital gains, or is there a limit?
Don't trust me, look it up. https://www.irs.gov/forms-instructions-and-publications
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Re: Capital gains in taxable accounts - Why is it that bad?

Post by Geologist »

vxdx wrote: Sun Jan 23, 2022 2:46 pm This discussion has made me question a belief I had, and I’d appreciate someone’s insight.

If I buy into a fund at 1000 and immediately am hit with a capital gains distribution, I would pay tax on that distribution even though it’s not a capital gain to me, right? Essentially I’m taxed on the funds gains from before I invested.

Is there no way to justify in my own taxes that I did not personally realize any gains?

Would this be true for the fund in perpetuity? I.e. if this fund has total gains since inception of 99%, but has distributed none of it, is it possible for almost all of the value to be distributed at some point in the future as capital gains, or is there a limit?
If you received a distribution, under the tax code, you received it and "benefitted". It is a capital gain to you for tax purposes. This is why there is advice to avoid "buying a distribution".

If a fund has unrealized gains (and that is the technical term for having "distributed none of it"), then the fund could distribute those at a later time. Will a fund distribute these all at once? Hard to say.

You can find out how much a fund has in unrealized gains. Keep in mind that if the market goes up, unrealized gains go up (and can stay up over time if the fund is at least partially tax-efficient), then unrealized gains will increase, but if the market goes down, they will decrease.
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Re: Capital gains in taxable accounts - Why is it that bad?

Post by nolesrule »

vxdx wrote: Sun Jan 23, 2022 2:46 pm This discussion has made me question a belief I had, and I’d appreciate someone’s insight.

If I buy into a fund at 1000 and immediately am hit with a capital gains distribution, I would pay tax on that distribution even though it’s not a capital gain to me, right? Essentially I’m taxed on the funds gains from before I invested.

Is there no way to justify in my own taxes that I did not personally realize any gains?

Would this be true for the fund in perpetuity? I.e. if this fund has total gains since inception of 99%, but has distributed none of it, is it possible for almost all of the value to be distributed at some point in the future as capital gains, or is there a limit?
It's just like with dividends. The value of an individual share will drop by the amount of the distribution per share, so you might be left with a share with unrealized losses or at least a reduction of gain equal to the amount of the distribution, plus the capital gain distribution. They will net out ignoring taxes.

It's the taxes part that's being discussed.
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