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A sign outside of the headquarters of the investment management company, The Vanguard Group in Malvern, Pennsylvania on May 24, 2015.
A sign outside of the headquarters of the investment management company, The Vanguard Group in Malvern, Pennsylvania on May 24, 2015.
Kris Tripplaar/Sipa USA—AP

Some mutual fund investors, including ones at fund giant Vanguard, could face an unexpected tax hit this year.

Typically, mutual fund investors only have to worry about capital gains when the market is booming -- not this time around. Despite the fact that the market is up only about 1% for 2018, investors in many funds could end up owing taxes on gains those funds realized by trading stocks or other securities throughout the year.

That includes several funds from Vanguard -- the mutual fund giant with a cult-like following among investors -- which has long been known for it's prowess in helping investors avoid such pitfalls.

Vanguard’s Capital Opportunity Investor (VHCOX), for example, expects the distribution to reach nearly 9% of the net asset value (NAV) of the fund. Last year, the same fund had a distribution of nearly 4%. The Vanguard Mid-Cap Growth (VMGRX) will have a 12.7% distribution, compared to 3% last year.

A Vanguard spokesperson said, given the recent bull market, capital gins were "not surprising," but urged investors to consider keeping actively managed funds -- which are more likely to pass out gains than index funds -- in tax-advantaged retirement accounts like 401(k)s or IRAs.


Index Funds

While moves by Vanguard inevitably attract extra attention, fund researcher Morningstar Inc. says that across the fund industry capital-gains distributions are likely to be on par with last year, despite the market's weak performance in 2018. In 2017, when the market was up 17%, 65% of stock funds passed out a distribution.

Why are mutual funds giving out so many gains -- especially when the market has barely risen? Blame index funds. According to Christine Benz, Morningstar’s director of personal finance, it’s a mix of a multi-year bull run in the market and the flight of investor money moving from actively managed funds into index funds.

Funds try to limit capital gains distributions each year. But over the past decade, as the market has moved forward, it has created holdings in funds that have appreciated considerably. When investors pull their money out of a fund, it requires the managers to sell holdings. Since actively managed funds have seen a multi-year decline in money flowing out – including nearly $23 billion in outflows in the last two months – it’s forcing managers to sell holdings that had appreciated during the market run-up. Once sold, the distributions are handed out to its investors.

“Those distributions, in turn, are made to a reduced group of shareholders,” wrote Benz. “That's where big capital gains distributions come in.”

What to Do

A capital gains distribution of, say, 3% means essentially that a mutual fund is handing you back 3% of the value of your investment in the fund. While finds will automatically re-invest the money for you, the distributions represent trading profits, which you must pay taxes on, unless you hold the fund in a tax-friendly vehicle, like an IRA or 401(k).

Capital gains tax rates range from 0% to up 20%, depending on your income. Some high earners may also owe an additional 3.8% in net investment income tax. There are also state taxes to take into account.

There are some pieces of good news. While no one likes a surprise tax bill, paying taxes on capital gains realized in 2018, should lower your tax bill when you eventually do sell off your mutual fund shares. You don't get taxed twice.

In addition, if you have losses in another part of your investment portfolio, you may be able to avoid paying a tax bill on this year's capital gains altogether. You can do that by selling your losers to create a capital loss to offset any capital gains. However, if you do this, be aware that you can't repurchase the same stock within a month's time following the sale. If you do so, you would trigger the stock-wash rule, which would disallow the deduction that year.