Transcript
With many of the world’s stocks down this year, some mutual fund investors are in for an unpleasant surprise. Their account may be down, yet they may still owe taxes on gains. How does that happen?
Stocks and bonds are capital assets. When you sell a capital asset for more than its basis, you experience a capital gain for tax purposes; if you sell for less, you have a capital loss. The same thing happens when a mutual fund manager sells a holding, the fund realizes the resulting gain or loss. Now, fund managers buy and sell securities at will throughout the year. Mutual funds are required by law to pay virtually all net gains realized during the year to their shareholders as capital gain distributions. When this occurs in a non-retirement account, the distributions are taxable even if you did not sell anything, even if you reinvest the distributions, and even if the value of your holding has dropped. We cannot control what fund managers do, but we can be smart about fund taxes from the start. We structure portfolios with a high level of tax awareness and implement in tax wise ways. We proactively monitor holdings for capital gain distributions so that we can make informed decisions about tax management. And while we don’t try to trade to outguess the market’s next move, we won’t hesitate to execute trades as a tactical matter in an attempt to save our clients some tax money.
Taxes can get complex, but with sound planning, we can minimize the common mistakes of either ignoring or obsessing about taxation. Managing taxes is far better. To learn more about mutual fund taxation and tax-wise investing, visit the blog page of our website for the post titled Understanding Capital Gain Distributions. If you have any questions, please contact us. We would love to hear from you.
Capital gain distributions can affect the bottom line for mutual fund investors. The newspaper reports that fund A returned X%, while fund B returned 1% less. Many people will assume that Investment A was superior. This is not always the case for several reasons, but we will focus on one in particular today – taxes. Taxes are by far the largest expense a portfolio may incur. We employ many tax management techniques, but will only employ those strategies and tactics that we believe will aid a client in reaching their particular financial goals.
The databases that most publications use to list the performance of various investments almost universally ignore taxes. As financial planners, we discourage ignoring taxes as much as we discourage obsessing about taxes. Either one can cause problems. Managing taxes is preferred.
…we discourage ignoring taxes as much as we discourage obsessing about taxes. Either one can cause problems. Managing taxes is preferred.
In the above example, it could be the case that the after-tax return for owning B is better than that for owning A. This can happen in several ways:
- Taxable Income: B may be invested in securities that simply do not give off much taxable income, like some stocks or municipal bonds, while A may invest in things that generate considerable taxable income.
- Tax Rate: The tax rate that applies can be different, too. “Qualified dividends” are taxed at low long-term capital gain rates, but other dividends, such as those from Real Estate Investment Trusts and many foreign companies, are taxed at the rates on ordinary income.
- Management Approach: Some funds are managed in a tax-efficient manner, but others are not concerned with tax consequences at all. This is the time of year we see how the management approach can affect a tax return.
Why Capital Gain Distributions Exist
Stocks, bonds, and mutual funds that invest in stocks and bonds are considered capital assets. When you sell a capital asset for more than its “basis,” you experience a capital gain for tax purposes. Sell for less than the basis, and you have a capital loss. Likewise, when a mutual fund manager sells a holding in a fund, the fund realizes the resulting capital gain or loss. Fund managers buy and sell securities at will throughout the year.
Mutual funds are required by law to pay virtually all net gains to their shareholders in capital gain distributions. When this occurs in a taxable (non-retirement) account, you pay taxes on the distributions. There is no tax consequence when this occurs in a retirement account such as an IRA. These distributions typically occur once or twice a year, most frequently in December.
When a capital gain distribution is made, the fund’s share price will be reduced by the amount of the distribution.
How Capital Gains Are Distributed
For example, a fund share sells at $10. A net profit of $2 a share has accumulated in the fund during the year from the manager’s sales. A capital gain distribution of $2 will be deducted from the share price on a specified date. On that date, the price will decline to $8. The holding is still worth $10, but its form has changed. The original shares are priced at $8, but you have $2 cash in your pocket or the cash account of your brokerage account. If you automatically reinvest your capital gain distribution, it buys you $2 worth of additional fund shares at the new, lower price of $8.
Dividend reinvestment works like this: If you bought 1000 shares of a fund for $10,000 and the price is still $10 a share, your cost basis and your account value are both $10,000. If the fund pays a capital gain distribution of $2 a share ($2,000) the price drops to $8 a share, and your original 1000 shares are now worth $8,000. When reinvesting the dividends, the $2,000 distribution would buy you $2,000 worth of shares at $8 per share or 250 shares ($2,000 divided by $8). You now own 1250 shares worth $8 each, for a total of $10,000, which was your original account value before the capital gain was paid. Your cost basis is now $12,000 ($10,000 from the original purchase plus $2,000 in gain distributions).
If you did not know the distribution was coming, it would look as though the fund dropped $2 in value or 20% when you looked up its quote for the day. About this time every year, we speak to people who are surprised to see the value of one or more of their funds drop significantly on a day when the market hasn’t gone up or down much. A capital gain distribution is often the cause.
Note that you made no money in this example, but now owe taxes on $2,000 of gains. Come April, that can be an unpleasant surprise to the unwary.
Managing Taxes From Capital Gain Distributions
Our clients are unlikely to be blindsided by such surprises. We cannot completely control what fund managers do, but we can minimize surprises by exercising a high level of tax awareness and implementing tax savings techniques where appropriate. We structure portfolios intelligently and implement in tax-wise ways using investment vehicles that are inherently more tax efficient in taxable accounts from the start. Furthermore, we proactively monitor your holdings for capital gain distributions so that we can make informed decisions about tax management. And, while we don’t try to trade to outguess the market’s next move, we will not hesitate to execute trades as a tactical matter in an attempt to save our clients some tax money.
We often say, “Focus on what can be controlled.” As we approach the end of 2014, we turn our attention to year-end planning. Taxes are high on our list of things over which we can exercise some control. It can get complex, but we are happy to look out for these details on your behalf. Of course, we would be happy to explain exactly which elements of this affect you individually.
Contact Us
If you have any questions or would like to discuss this further, please give us a call or send us a note.
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