Don’t Pay a Loyalty Tax

Mutual fund shareholders who stay are paying for the ones who left. You don’t have to.

• • Distribution season came early and came in heavy. By mid-October, 284 funds were already estimating payouts above 10% of NAV, with most fund firms still to report.

• • The money leaving mutual funds for ETFs is likely what is generating the gains, with the tax impacting whoever stayed.

• • One large fund family’s own estimates show the gap: double-digit distributions across its flagship mutual funds, none across its ETFs.

• • Over 20 years, that drag may be the difference of $50,000 on a $100,000 taxable investment depending on returns, and a few simple moves may help reduce it.

There is a tax on staying in a mutual fund, and it seems to be moving higher up. Last November we wrote about the pain of end-of-year mutual fund distributions, which generate phantom income that shows up when a fund sells appreciated stock on your behalf, even when you aren’t in need of the proceeds. That post explained the mechanics. This one is about who is paying it, why the bill is getting bigger, and some potential ways to mitigate it.

What’s New Since Last November

It started earlier, and it is bigger. Last year’s post ran in November, after Morningstar’s annual review. This year the estimates were out in September. As of October 18, CapGainsValet had tallied 54 fund firms with 2026 estimates posted, out of 359 it tracks. Among those, 220 funds expect to distribute 10%-20% of NAV, 46 expect 20%-30%, and 18 expect more than 30%. That is 284 funds above 10%, with roughly 85% of firms still to report.

Index funds are in the doghouse. CapGainsValet’s 2026 list of funds expecting payouts above 20% of NAV includes an S&P 500 index mutual fund and a mid-cap index fund, which removes the usual explanation of trading too much. What likely happened was their shareholders left, and the fund was forced to sell appreciated holdings to pay them.

One manager published both answers. One of the largest mutual fund families in the country posted its preliminary estimates in September, and the mutual funds and ETFs sit on the same page. Its flagship growth fund expects to distribute 20% to 25% of NAV. Its balanced fund, a 60/40-style portfolio, expects 12% to 15%. Its core, small-cap, and large-cap growth funds all expect 10% or more, and most of the rest of the equity lineup lands between 8% and 12%. Of the same firm’s 25 ETFs, 24 are estimated to have no capital gain distribution at all; the one exception is a municipal ETF estimating up to half a percent. Same firm, same research system, overlapping holdings. Different wrapper, different outcome.

The flow data points the same way. ETFs took in $1.23 trillion through July, on pace for the largest year of inflows the industry has recorded. A lot of that money came out of mutual funds. Every dollar that left was a dollar the fund had to raise by selling.

How the Loyalty Tax Works

When a shareholder redeems, the fund sells appreciated stock to pay them. The gain is realized at the fund level and distributed to everyone still holding on the record date. The shareholder who left pays tax on their own gain and nothing more. The shareholders who stayed pay tax on the leaver’s gain too.

So the longer you have held, the larger your share of everyone else’s exit. It is, literally, a tax on loyalty.

And the cycle inherently reinforces itself. A big distribution prompts more exits. More exits force more selling. The fund shrinks, the remaining base gets smaller, and next year’s distribution gets bigger per share. Shrinking funds do not un-shrink. ETFs break the loop because an authorized participant takes appreciated shares out in kind; nothing gets sold, nothing gets realized, and the shareholders who stay are not asked to pay for the ones who leave.

What It Costs

This year’s bill first. A client with $500,000 in a taxable account in a fund estimating a 12% to 15% distribution is looking at $60,000 to $75,000 of gains they did not choose to realize. At the top federal long-term rate plus the potential 3.8% net investment income tax, that is roughly $14,000 to $18,000 in Federal taxes before state tax. In California, closer to $22,000 to $28,000. The account value does not change on the ex-date. Only the tax bill is new.

The long-run number is the one that matters. Take $100,000 earning 8% a year in a taxable account. One version (let’s call it an ETF) pays capital gains tax once at the end. The other (let’s call it a mutual fund) realizes and distributes its full return every year, which is where a shrinking mutual fund tends to end up. Both are taxed at 23.8%.

Assuming the same 8% compounded return every year, the distributing fund’s after-tax return is stuck at 6.1% a year no matter how long it is held. The deferred version’s after-tax return rises with time: 6.5% at ten years, 6.9% at twenty, 7.1% at thirty. Same stocks, same 8% before tax. By year thirty, deferral is earning a full extra point a year, and that is with no state tax. A fund that distributes half its return each year gives up about half as much.

Potential Ways to Mitigate the Burden

None of these ideas requires selling a position with a large embedded gain. Most of the mitigation is in what you do with the next dollar.

Check the estimate on every mutual fund in a taxable account. Estimates are posted now. Most firms update in early December, so check again before the record date.

Think twice before buying the distribution. New money into a mutual fund ahead of its record date is buying someone else’s tax bill. Consider waiting until after the ex-date, or using an ETF.

Reconsider automatic reinvestment. This is the move that gets overlooked. One alternative is to take the distribution in cash and put it in the ETF version instead. The tax is owed either way. Taking it in cash shrinks the mutual fund position without a sale, and the next dollar compounds in a wrapper structured to avoid this problem.

For positions already slated to leave, run both paths. Compare the gain on selling before the record date against the gain on taking the distribution. Sometimes the sale is cheaper. Sometimes it is not. Decide on the numbers, not on the estimate alone.

Consider ETFs for new taxable money. The manager decision gets all the attention. In a taxable account, the wrapper decision is the one that shows up on the 1099.

Loyalty is usually rewarded. In a mutual fund in 2026, it is taxed. Don’t pay it.

Disclosures

Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The information contained herein should not be considered a recommendation to purchase or sell any particular security. Forward-looking statements cannot be guaranteed.

Projections or other forward-looking statements regarding future financial performance of markets are only predictions and actual events or results may differ materially.

This commentary offers generalized research, not personalized investment or tax advice. It is for informational purposes only and does not constitute a complete description of our investment services or performance. Nothing in this commentary should be interpreted to state or imply that past results are an indication of future investment returns. All investments involve risk and unless otherwise stated, are not guaranteed. Be sure to consult with an investment & tax professional before implementing any investment strategy.

Investing involves risk. Principal loss is possible.

 Information presented in the above charts labeled “conceptual illustration” are for illustrative purposes only and should not be interpreted as actual performance of any investor’s account. As these are not actual results and completely assumed, they should not be relied upon for investment decisions. Actual results of individual investors will differ due to many factors, including individual investments and fees, client restrictions, and the timing of investments and cash flows

Distribution estimates referenced above are preliminary, published by the respective fund companies, and subject to change before the distribution date. No specific fund is being recommended for purchase or sale. The long-run illustration is conceptuall: it assumes a constant 8% annual return, a 23.8% tax rate on distributions and on gains at sale, full reinvestment of after-tax distributions, no state tax, no fees, and no market fluctuation. Actual results will differ.

Advisory services are offered through Aptus Capital Advisors, LLC, a Registered Investment Adviser registered with the Securities and Exchange Commission. Registration does not imply a certain level of skill or training. More information about the advisor, its investment strategies and objectives, is included in the firm’s Form ADV Part 2, which can be obtained, at no charge, by calling (251) 517-7198. Aptus Capital Advisors, LLC is headquartered in Fairhope, Alabama. ACA-2610-30.