Your Portfolio Has a Tax Disaster. Now What? 

“Wait a minute—that can’t be right.”

I had a few of those moments as I was helping family members gather up their tax documents this tax season. Even people who don’t have especially large accounts received large taxable income distributions in 2025, the result of the higher interest rates now on offer in various cash and bond investments in their portfolios.

And I had similar sticker shock when looking at my own 1099s, especially from the excellent stock mutual fund that we’ve long held in our taxable account. Its capital gains distribution was so large in 2025 that even our accountant said he did a double-take. “I hope it had a good year, at least,” he commented.

I know, it doesn’t make sense to hold actively managed funds in a taxable account; to the extent that you own them, and you could reasonably eschew them altogether, they belong in a tax-sheltered account like an IRA. Same goes for investments that kick off a lot of ordinary income, like some of my family members have.

The question is: If you have one of these bad tax situations in your taxable account, what are your options? Let’s take a closer look at these scenarios.

Tax Problem: Big Capital Gains Distributors

Many actively managed US stock funds have made big capital gains distributions—often a series of them—over the past decade. Stock market performance has been excellent over that period, so holdings may have hit management’s price targets for them. Moreover, many funds have had to meet investor redemptions as investors have swapped into index funds and exchange-traded funds. That activity has also exacerbated the capital gains distributions, as managers have had to sell shares to meet investor outflows.

Of course, those big capital gains distributions don’t matter if you own a fund in a tax-sheltered account like an IRA. Ditto if you’re in the 0% bracket for long-term capital gains. But if you hold the fund in a taxable account and aren’t in the 0% capital gains bracket, as is the case with me and Vanguard Primecap Core VPCCX, those distributions can erode your aftertax returns. The fund has returned 15.98% before taxes over the past decade, but its 1.77% tax-cost ratio takes its aftertax return to 14.21%. Meanwhile, a naturally tax-efficient fund like Vanguard Total Stock Market Index VTSAX

has had a lower 10-year annualized pretax return of 15.03%. But because its tax-cost ratio is a much lower 0.46%, its aftertax return is 14.57%. (Note: Those tax-cost ratios assume that the investor is in the highest tax bracket over the whole period, which may or may not be the case. If you’re in a lower tax bracket, your tax bill would be lower.)

Here are the two major options someone in this situation could consider:

Option 1: Sell the whole position.

If a position is relatively new and your cost basis in it is fairly high, making a clean break by selling out of the position may be a viable course of action. Just remember that, in addition to the taxes due when the fund itself makes a capital gain or income distribution, you also owe taxes when you sell a position that has appreciated since you purchased it. Thus, before selling, you’ll want to check your cost basis relative to the value of your holdings today. The good news is that any capital gains distributions that you’ve reinvested and paid taxes on have increased your cost basis. You’ll also want to make sure you’ve held the position and not made any new contributions within the past year; otherwise, your gains on the sale of those holdings will be dunned at your ordinary income tax rate, rather than the long-term capital gains rate.

Option 2: Stop reinvesting dividends and capital gains, and reinvest them in something more tax-efficient.

This is a more incremental step to deal with a serial capital gains distributor and is the best option if selling the position outright would trigger a big tax bill in a long-held position that you continue to have conviction in. (This is my situation with Primecap Core.) Rather than reinvesting dividend and capital gains distributions back into the fund, you’d steer them into another holding in your portfolio, either a more tax-efficient equity fund (like the aforementioned total market index) or into some other asset class that needs topping up. If you’re still building your position in the same asset class, you could (and probably should) stop making new contributions to the serial capital gains distributor and send new contributions to another holding instead.

Tax Problem: High Income Distributors

In contrast with the above example involving stock funds making big capital gains distributions, this scenario is more common in the realm of safer investments like bond and cash holdings. The income distributions from such holdings are taxed at your ordinary income tax rate. When interest rates and, in turn, income distributions from safer investments were low, this wasn’t such a big deal, at least in dollars and cents terms. (Ordinary income tax was still gobbling up a big share of income distributions when yields were lower, but it didn’t affect investors’ actual tax bills as much.) But now that interest income is more meaningful, so are the associated tax bills.

To use a simple example, a total bond market index fund like Vanguard Total Bond Market Index VBTLX would have returned about 4% over the past year, but its tax-cost ratio is 1.67%, nearly half of its return. That’s because all of the fund’s gains came from income distributions, which are taxed at the investor’s ordinary income tax rate.

The good news is that because most, if not all, of such funds’ distributions have come from income, you’ve been paying taxes on those distributions as you’ve gone along, so repositioning for tax reasons is unlikely to trigger a big tax bill. You’ve already paid it. (Caveat: That’s not true for every type of bond fund. Categories like high-yield bonds also tend to derive a portion of their total returns from appreciation in their securities’ value as well as income distributions, so you may owe some capital gains tax upon sale. But it’s generally true for higher-quality bond funds.)

Here are the two options to consider in this situation. The right answer will depend on the reason you’re holding bonds and cash.

Option 1: Sell and hold bonds elsewhere.

If you’re holding bonds and cash instruments primarily for diversification purposes and to reduce volatility in your overall portfolio rather than to meet short- or intermediate-term spending obligations, the likely best course of action is to sell bonds from your taxable portfolio and enlarge their weightings in your tax-sheltered accounts. The taxes due upon that sale should be limited, as noted above. And as long as you’re reinvesting those income distributions back into your holdings in your IRA or other tax-sheltered vehicle, you won’t owe taxes on them. You can then use your taxable portfolio for more tax-efficient investments such as equity index funds and ETFs.

Option 2: Stand pat with bonds but consider munis.

Alternatively, if you want to continue to hold bonds or cash in your taxable portfolio to provide ongoing cash flows or to serve as your emergency fund, it’s helpful to run the numbers on whether municipal securities may not be a better bet. Use a tax-equivalent yield calculator to plug in your own tax situation and details on the type of bond or bond fund that you’re considering. The attractiveness of taxable bonds relative to municipals will ebb and flow based on various factors, but your tax bracket is a major input. If you’re in a lower tax bracket, taxable bonds may still be the better option, even after factoring in the tax implications. But higher-tax-bracket investors—say, those in the 24% tax bracket and above—may be better off in a municipal-bond fund or money market fund.