It's tax time for fund investors, even those doing nothing

The end of the year can mean tax headaches for some mutual-fund investors, this year potentially more so than others.

Companies have started to warn investors of distributions they'll make by the end of December. For anyone with a fund outside a tax-advantaged account, these payments can trigger a tax bill, even if they never sold any shares themselves.

The biggest distributions typically come from actively managed funds, which are ones that try to beat index funds. Many investors are abandoning these kinds of funds, and the departures could lead to bigger-than-usual tax bills for those shareholders that remain. So could the stock market's record-setting performance since election day.

The distributions are a result of how mutual funds are set up. Each year, fund managers tally their winnings from selling stocks and bonds and then pass them onto shareholders.

Many of these distributions are worth about 5 percent of the fund's total value. In that case, a fund that trades for $100 would pay a $5 distribution to shareholders, and its share price would drop to $95 simultaneously. Taxpayers would then be liable to pay taxes on the $5. On the higher end, these kinds of distributions can be worth more than 15 percent of a fund's value, and the higher levels can put that much heavier a drag on returns.

"The industry focuses on pretax returns," says Frank Pape, senior director of consulting services at Russell Investments. "But for investors, the meaningful number is the after-tax return."

People who own mutual funds only through a 401(k), Individual Retirement Account or another tax-advantaged account don't need to worry about gains distributions. They won't pay a cent of taxes on them until it's time to make a withdrawal.

But trillions of dollars in mutual funds are nevertheless held in taxable accounts. Last year, $44 of every $100 paid out in capital-gains distributions went to a taxable household account, according to the Investment Company Institute.

Investors are more likely to get hit with these distributions when the market is doing well, because that's when managers are most likely to be selling winners. So the strong bull run for stocks since 2009 has led to a steady rise in payouts. After paying $15 billion in gains distributions during 2009, when the stock market bottomed following the Great Recession, funds paid out $400 billion five years later.

This year, the Standard & Poor's 500 index rose 15 percent in the first 10 months. Many foreign stock markets fared even better. That makes it more likely that when fund managers made portfolio moves this year, they booked a gain that will eventually get passed along to shareholders.

The other factor pointing to big gains distributions this year is the continued exodus from actively managed funds. For years, investors have watched index funds charge lower fees and put up better returns than the majority of actively managed funds. That's led to a tidal shift in dollars.

In the 12 months through September, investors pulled nearly $239 billion out of actively managed U.S. stock funds, according to Morningstar. With so many investors heading for the exits, managers of actively managed funds have to sell stocks and bonds to raise cash to meet the redemptions. And more sales can trigger yet more gains.

Last year, 50 percent of all stock-fund share classes made a distribution to their investors. Five years earlier, only 24 percent did so.

To be sure, last year actually saw a drop in gains distributions, to $220 billion across the industry from $379 billion. That could be because many funds end their fiscal years in October. Those funds closed their accounting books for the year before the big spurt for markets following the Nov. 8, 2016 election.

The S&P 500 was up a modest 2 percent between Oct. 30, 2015 and Oct. 31, 2016, but it surged 21 percent in the ensuing 12 months. That could lead to bigger gains distributions this year.

Funds that invest in technology stocks look particularly vulnerable for gains distributions this year. That's because Apple and other tech giants have been far outpacing the rest of the market. Growth stock funds, which often include tech stocks, could also be in line for big distributions.

So, what should investors do? First, Russell's Pape says, is not to let tax considerations be the top motivator. Don't sell a fund just to avoid a tax bill. The long-term goal should always be the best after-tax gains in the long term, with an acceptable amount of risk.

Second, remember that certain types of funds are more prone to gains distributions, such as those that trade often. Index funds tend to have smaller distributions, though they're certainly not immune.

One category of mutual funds has been built specifically with taxes in mind. These are often called "tax-managed funds," and they try to trade less often and use other methods to limit gains distributions.