LAS VEGAS — As 2025 winds down, many investors are bracing for year-end mutual fund distributions, which can trigger a hefty tax bill for assets held in a taxable brokerage account. But there are strategies to avoid the payout, experts say.
For 2025, “youve got some pretty eye-watering numbers,” with some funds planning to distribute double-digit capital gains, said Brandon Clark, director of exchange-traded funds for asset management firm Federated Hermes.
After another strong year for the stock market, more than 10 mutual funds are estimating payouts of at least 25%, with most distributions expected to come around late November through year-end, according to a Morningstar report published on Monday.
If you own these mutual funds in a brokerage account, you could pay taxes on the capital gains payouts, even when you reinvest the proceeds. Those reinvested gains lower your “basis,” or the assets original purchase price, which can help reduce future profits.
Still, “the ETF solves a lot of those [yearly tax] problems,” said Clark, speaking at the Financial Planning Associations annual conference on Tuesday.
Let’s face it – nobody wants to open their tax bill and discover they owe money on mutual funds that lost value during the year Yet that’s exactly what happened to many investors in 2022 when two-thirds of mutual funds made capital gains distributions despite the S&P 500 dropping more than 18%
I’ve been there myself Last year, I got slapped with a hefty tax bill on mutual funds I hadn’t even sold! After that painful lesson, I dove deep into researching how to avoid this common investment pitfall.
With 2025 winding down and many mutual funds preparing to distribute double-digit capital gains according to Morningstar, now’s the perfect time to protect your investments from unnecessary taxation
Why You’re Paying Taxes on Mutual Funds (Even When You Don’t Sell)
Before diving into solutions, we need to understand why this happens.
When you own a mutual fund in a taxable account, you’re on the hook for:
- Capital gains taxes when the fund manager sells securities within the fund at a profit
- Taxes on dividend income distributed by the fund
- Taxes on interest income generated by the fund’s holdings
The kicker? These tax obligations apply even if you reinvest all distributions back into the fund and never sell a single share yourself!
Even worse, as Brandon Clark, director of exchange-traded funds at Federated Hermes, noted recently: “For 2025, you’ve got some pretty eye-watering numbers,” with some funds planning to distribute double-digit capital gains percentages.
5 Effective Strategies to Avoid Mutual Fund Tax Surprises
After consulting with tax professionals and studying both the CNBC and Fidelity resources, I’ve identified these five strategies to minimize or eliminate taxes on your mutual fund investments:
1. Use Tax-Advantaged Accounts When Possible
The simplest solution is often the best. By holding mutual funds in tax-advantaged accounts like:
- Traditional IRAs
- Roth IRAs
- 401(k)s
- 403(b)s
- HSAs (for health-related expenses)
You can defer (or in some cases, completely avoid) taxes on distributions. This strategy, often called “tax-smart asset location,” involves strategically placing investments in accounts based on their tax efficiency.
Pro tip: Keep your most tax-inefficient mutual funds (like those with high turnover ratios that generate frequent capital gains) in tax-advantaged accounts whenever possible.
2. Switch to ETFs (Exchange-Traded Funds)
As the CNBC article points out, “the ETF solves a lot of those [yearly tax] problems,” according to Brandon Clark.
ETFs offer significant tax advantages over traditional mutual funds:
- They use a creation/redemption process that allows for “in-kind” trades, which are generally tax-free
- Most ETFs don’t make year-end capital gains distributions
- They typically have lower turnover ratios than actively managed mutual funds
When switching from mutual funds to ETFs, timing matters. You should:
- Calculate potential gains from selling your current mutual funds
- Compare those gains to expected year-end payouts
- Sell before the mutual fund’s “record date” to avoid receiving the distribution
As Karen Van Voorhis, a CFP and director of financial planning at Daniel J. Galli & Associates, advises: do “a quick comparison” of the possible gain from selling vs. the year-end payout. Sometimes, it’s worth taking the one-time tax hit to “permanently flip to ETFs.”
3. Look for Tax-Managed Mutual Funds
If you prefer to stick with mutual funds, consider tax-managed funds specifically designed to minimize distributions. These funds:
- Focus on tax efficiency as a primary objective
- Use strategies like tax-loss harvesting to offset gains
- Minimize portfolio turnover to reduce realized gains
- Strategically time the buying and selling of securities
While these funds won’t completely eliminate taxes, they can significantly reduce your tax burden compared to standard mutual funds.
4. Consider Separately Managed Accounts (SMAs)
For investors with larger portfolios (usually $100,000+), separately managed accounts offer the ultimate in tax flexibility. With an SMA:
- You own individual securities directly (rather than fund shares)
- You can work with your advisor to implement tax-loss harvesting strategies
- You only pay capital gains taxes when YOU decide to sell securities
- You can customize your portfolio to avoid certain stocks or sectors
As Fidelity points out, “Owning an SMA in a taxable account helps investors with the capital gains distribution dilemma—capital gains taxes are only owed when the individual securities in the SMA are sold for a profit.”
Plus, SMAs offer additional tax benefits, like the ability to gift appreciated securities to charity without selling them, allowing you to deduct the fair market value while avoiding capital gains taxes.
5. Time Your Mutual Fund Purchases Strategically
If you must buy mutual funds in a taxable account, timing is crucial:
- Avoid buying mutual funds late in the year, especially in the fourth quarter
- If you buy just before a distribution, you’ll pay taxes on gains that occurred before you owned the fund
- Check fund company websites for estimated distribution dates and amounts
- Consider waiting until January for new mutual fund investments
As Tom Geoghegan, founder of Beacon Hill Private Wealth, emphasizes: “For mutual funds, you must sell before the record date to avoid receiving the distribution.”
Real-World Example: The 2022 Tax Trap
Let me share a quick example from 2022 to illustrate the problem:
Imagine you invested $10,000 in a mutual fund in early 2022. By December, your investment had declined to $8,200 due to market conditions (an 18% loss, matching the S&P 500’s decline).
However, the fund manager had sold some long-held positions that had appreciated over many years, generating capital gains equal to 7% of the fund’s value.
Despite being down $1,800, you’d receive a capital gains distribution of approximately $700 and owe taxes on that amount—even though your overall investment had lost value!
If you were in the highest tax bracket (20% for long-term capital gains), that’s a tax bill of $140 on an investment that lost money. Ouch!
My Personal Strategy: A Hybrid Approach
After getting burned by mutual fund distributions, I’ve adopted a hybrid approach:
- I keep all my actively managed mutual funds in my Roth IRA and 401(k)
- For my taxable brokerage account, I primarily use ETFs
- For larger positions, I’ve started using a separately managed account
- When I do buy mutual funds in my taxable account, I time the purchases for January
- I regularly review distribution estimates from fund companies in October
This strategy isn’t perfect, but it’s dramatically reduced my tax burden while still allowing me to maintain a diversified portfolio.
Common Questions About Avoiding Taxes on Mutual Funds
Do I still pay taxes if I reinvest all distributions?
Yes, unfortunately. Even if you never see the money and automatically reinvest all distributions, the IRS still considers this taxable income.
What’s the difference between short-term and long-term capital gains distributions?
Short-term gains (from securities held less than a year) are taxed as ordinary income, while long-term gains enjoy preferential tax rates (0%, 15%, or 20% depending on your income).
Will selling my mutual fund before distributions trigger taxes?
Yes, you’ll pay taxes on any appreciation since purchase, but you’ll avoid the distribution. Sometimes taking this hit makes sense if you plan to switch to more tax-efficient investments.
Are index funds more tax-efficient than actively managed funds?
Generally yes. Because index funds have lower turnover, they typically generate fewer capital gains distributions than actively managed funds.
Can tax-loss harvesting help offset mutual fund distributions?
Absolutely! If you have losing positions elsewhere in your portfolio, selling them can generate losses to offset capital gains distributions from your mutual funds.
Bottom Line: Be Proactive About Mutual Fund Taxes
With double-digit mutual fund capital gains distributions expected for 2025, now is the time to examine your portfolio and implement tax-saving strategies. A Morningstar study showed that taxes can reduce portfolio returns by up to 2% annually for investors who don’t account for them when making investment decisions.
Remember, it’s not just about how much your investments earn—it’s about how much you keep after taxes.
By understanding how mutual fund distributions work and implementing some of the strategies we’ve discussed, you can keep more of your hard-earned money working for you rather than sending it to Uncle Sam.
More from ETF Strategist:
Heres a look at other stories offering insight on ETFs for investors.
ETFs are generally more tax-friendly than mutual funds because of a “tax loophole” that exists for ETFs, Clark said.
Fund managers can make “in-kind” trades and redemptions, which are generally tax-free. As a result, most ETFs dont have year-end capital gains distributions.
However, if youre planning to swap your mutual funds for ETFs, there are some key things to know, experts say.
‘Do a quick comparison’ of possible gains
One of the challenges of trading mutual funds for ETFs is that many investors are sitting on significant gains, experts say.
You should “do a quick comparison” of the possible gain from selling profitable mutual funds vs. the year-end payout, said certified financial planner Karen Van Voorhis, director of financial planning at Daniel J. Galli & Associates in Norwell, Massachusetts.
If you sold, you would only incur the gains from mutual funds once vs. yearly payouts, she said. The upfront gain could be worthwhile to “permanently flip to ETFs.”