Don’t Let the Tax Grinch Steal Christmas
It is that time of the year again when children make their holiday gift lists, families get together to celebrate, and mutual funds pay out their capital gain distributions to unsuspecting shareholders. While some of those time-honored traditions may be different this year, one that will remain is the unwanted tax bills that accompany the distributions from mutual funds.
Everyone is familiar with the concept of capital gains. If an investor makes a wise investment and later sells it a higher price, then the investor has made money and realized a gain! The only catch is that the investor will have to share some of that profit with the government in the form of capital gains tax. The percentage owed on the gain varies depending on the investor’s income and length of time the investment was held so it is always best to consult your tax advisor for your specific situation.
What many investors are not familiar with is the concept of paying capital gains tax on investments they have not sold. Although investors may not have taken any action in their taxable portfolios during the year, the manager of their mutual funds likely did…and those trades are the source of the unwanted capital gain distributions. The inefficient structure of traditional mutual funds requires that net realized capital gains generated by the funds be paid out to the shareholders. In tax-deferred accounts, that is not a big deal. But in taxable accounts, this year-end surprise is like a giant lump of coal in your stocking.
Here is a simple example. Let us assume you own one of these mutual funds. That fund’s manager bought and sold assets inside the fund throughout the year. Some were short-term holdings. Others may have been in the fund for many years. If the fund manager’s trades produced net gains, you will receive an IRS Form 1099 that will show realized capital gains to be reported on your tax return. That is right, you owe taxes on someone else’s trades.
Now, suppose those gains are the result of the fund manager making trades to raise cash to satisfy redemption requests during a market-wide selloff, such as the one we experienced this past March. Here is the worst part – the shareholders who sold the fund got their cash, but because you stayed in the fund until the end of the year, you get stuck with the tax bill. That is right – Grinch strikes again – the capital gain distributions go to the remaining shareholders and not to those who caused the sales.
The amount of capital gain distribution will vary, but the concept is the same each year. Paying these taxes year after year is like filling up a bucket with water only to realize there is a small hole in the bottom.
At Legacy, we utilize tax-efficient ETFs (exchange traded funds) to avoid the above-described tax drag common in traditional mutual funds. After all, it is not about how much money you make – it is about how much money you get to keep.
If you are concerned about the mutual funds in your taxable investment account do not despair, you still have time to harvest other investment losses to offset those expected gains. In fact, you may still be able sell those mutual funds before being locked into receiving a taxable distribution!
If you are a Legacy client and have questions or concerns, please do not hesitate to contact your Legacy advisor. If you are not a Legacy client and are interested in learning more about our approach to personalized wealth management, please contact us at 920.967.5020 or info@lptrust.com.
Authors
Greg Hansen, Vice President & Senior Portfolio Manager
Peter Schaefer, Trust Investment Officer
This information has been prepared by Legacy Private Trust Company for informational purposes. Any opinions expressed herein represent our current analysis and judgment and are subject to change. Actual results, performance, or events may differ based on changing circumstances. No statements contained herein should substitute for professional legal, tax, or other specialized advice.
Laurene Brooks joined Legacy in 2004, shortly after the company’s inception. She earned undergraduate degrees in journalism and Spanish, and her Juris Doctor (JD) designation from Marquette University. Laurene has over 30 years of experience in law and relationship management. In addition to assisting clients with financial management and estate planning, Laurene is Legacy’s senior fiduciary officer. In addition, she was a member of the Real Property, Probate, and Trust Division of the Wisconsin State Bar for 10 years and served as chair.
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