CGV Intermediate – Keeping More of What You Make

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Between holiday shopping, decorating and goodie eating there is more than enough going on this time of year without worrying about the tax consequences from mutual fund capital gain distributions.

In 2014, I counted over 450 funds that distributed more than 10% of their Net Asset Value (NAV) and 50 of these distributed in excess of 20%!  Mutual fund information providers, fund marketers, and most fund managers focus on total investment returns, so they do not care much about taxable distributions.  Of course, total returns are very important, but it is not what you make, it is what you keep!  After-tax returns are what is most important for the taxable investor.

You can keep more of what you make by considering these factors before you make your investment:

  • Use funds with embedded losses or low potential capital gains exposures. Are there really quality funds that have little/no gains?  There are not many, but some good research may uncover some opportunities.  The most likely situations are when an experienced manager opens his/her own shop or when one takes over a failing fund and makes it their own.
  • Use funds with low turnover and with a long-term investment philosophy. Paying taxes on annual long-term capital gains is not pleasant; however, it is the short-term gains that are the real killer.  Short-term gains are taxed at your ordinary income tax rates.  Worse yet, short-term capital gains distributions are not offset by other types of capital losses, as these are reported on a completely different tax schedule.  Fund managers who trade frequently might have attractive returns, but their returns have to be substantially higher than tax-efficient managers to offset the higher tax hit they are generating.
  • Think about asset location. Putting your most tax-inefficient holdings in your tax-deferred accounts will help you avoid these issues.  Funds that typically have significant taxable income, high turnover, or mostly short-term gains should be placed in your IRA, Roth IRA, etc. High yield funds, REIT funds and many alternative strategies generally fit this category.
  • Use index funds or broad-based indexed ETFs. It is not easy to choose funds that beat comparable broad-based, low cost index funds or ETFs.  When taxes are added to the equation, the hurdle gets even higher.  Using index-based holdings in taxable accounts and active fund managers in tax-deferred accounts can make for a great compromise.

I hope considering these strategies will leave you with a little more to spend during the holidays.

 

 

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CGV Intermediate – Know When To Hold’em, Know When To Fold’em

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This article assumes you understand some fairly advanced tax concepts and terms (short-term gains, long-term gains, tax brackets, cost basis, etc.) – skip this if you are not well versed in these topics. Always consult with a tax professional before implementing any ideas communicated here.

 

Thanks to the information found on CapGainsValet, you should know when and how much your funds are going to distribute. How do you best use this information?

First of all – Do not buy any mutual fund before any substantial distribution in your taxable accounts.

The next step is not so simple. Should you simply hold on, take your lumps and pay Uncle Sam or should you sell before you get that ugly distribution? Deciding if you should “hold’em or fold’em” requires a little bit of work. Consider the following cases:

Case 1 – Peggy owns $15,000 of the Tax-Inefficient Growth fund. The fund is estimating a 5% short-term gain and a 20% long-term gain distribution in December. Peggy bought the fund back in 2009, so her cost basis in the fund is $9,000. Peggy is in the 25% (ordinary) federal tax bracket and will pay 15% on long-term capital gains (I’m ignoring state taxes to keep the numbers a little simpler).

  • Holding the fund will result in $750 of short-term capital gains and $3,000 of long-term capital gains. Tax bill: $638.
  • Selling the fund before the distribution will result in $6,000 of long-term capital gains. Tax bill: $900.
  • Hold’em! Holding the fund appears to be a better result. (If Peggy has realized losses or a loss carryforward, selling might make sense instead.)

Case 2 – George owns $10,000 of the Tax-Inefficient International fund that he bought a couple of years ago (cost basis: $9,000). The fund is estimating they’ll pay out a 10% short-term capital gain distribution next month. George is in the 25% federal tax bracket and will pay 15% on long-term capital gains.

  • Holding the fund will result in $1,000 of short-term capital gains. Tax bill: $250.
  • Selling the fund before the distribution will result in $1,000 of long-term capital gains. Tax bill: $150.
  • Fold’em! Selling the fund will save George enough to get a fairly nice dinner.

These two examples should give you an idea of the thought process you might use to determine your strategy, but there are any number of combinations. Estimated distribution amounts, current and future tax rates, current and past realized gains/losses, the fund’s cost basis (and other factors) should all be considered before making a trading decision. The bottom line is that there are no hard and fast rules here, you have to run the numbers.

 

Side Note: We run these numbers for our wealth management clients at the end of every year. This requires hundreds of calculations, a solid understanding of each client’s tax situation and a proactive investment team who focuses on after-tax wealth. One recent “hold ’em or fold ’em” review resulted in a number of trades that (combined) saved our clients $30,000 to $40,000 in 2015 taxes!

 

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CGV Intermediate – Heading Towards the Doghouse?

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Each year I find tens of funds that have distributions over 20% of their NAV. (See my “Doghouse” list in the Articles section of this site.) These funds will create tax issues for shareholders that own these in taxable accounts.

As it turns out, there are some indicators that your fund might have bigger than average distributions in the near future:

  1. High Turnover – Fund managers that are buying and selling then buying and selling then buying and selling again are going to (hopefully) realize gains along the way. These gains will be passed along to shareholders each year. Worst of all, if the fund is grinding out short-term gains, these are taxed as ordinary income and will be taxed at your highest tax rate.
  2. High PCGE – Potential Capital Gains Exposure (PCGE) is a number that indicates the current embedded gains in a fund. For example, a PCGE of 50% means half of the fund’s value is considered gain if sold. Low or negative (indicating embedded loss) PCGE funds aren’t likely going to make big distributions. PCGE numbers can be found through some of the mutual fund information services.
  3. Shrinking Fund – A fund that is losing a good portion of their assets has two problems that they are not able to control: (a) The fund has to sell securities to raise the cash needed to make fund payouts; these sales can result in capital gains that will increase the amount they will have to pay out. (b) Funds only distribute to the shareholders still in the fund on its record date. For example, a fund that loses half of its assets will double the distribution percentage they will make to the remaining shareholders.
  4. New Management – When there is management change at a fund, there can be some major holdings changes in that first transition year. Some takeover managers have styles that fit well with the current holdings and require few trades, some “morph” the fund to meet their styles over time, and some trade virtually the entire portfolio in a very short period making it their own. It’s good to find out which of these is the case when there is a management change in your fund.

For the most part, funds on the Doghouse list are shrinking funds and funds with management changes (sometimes both). Either of these might be a good reason to reevaluate the fund even if taxable distributions are not an issue.

 

 

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CGV Basics – Bitten by a big capital gains distribution? There might be a simple remedy.

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Are you investing in taxable accounts? Did your fund make a large distribution that was larger than your actual gain? Most investors think they have to bite the bullet, pay the taxes due using the experience as an expensive lesson. There is likely a better solution, however.

Let’s assume you purchased $10,000 of BCD fund in your taxable account on Dec 1st and the fund made a long-term capital gain distribution of $4,000 on Dec 3rd. Ouch! Unfortunately, there is nothing you can do about reporting the additional $4,000 in capital gains on your tax return. The good news is that you can sell the fund before the end of year and this will help the situation.

How does this work?

If you are reinvesting your distributions, the value of your holding will still be $10,000, but your cost basis is increased by the distribution you received. With a $14,000 cost basis- selling the fund will result in a $4,000 tax loss. The $4,000 long-term gain from the distribution is offset by the $4,000 loss on the sale. Ta da!

If you do not reinvest this distribution then the result is the same. In this scenario the BCD fund value is now $6,000, but your cost basis is $10,000. Selling will lock in the $4,000 loss. Ta da, again.

Selling a fund you just purchased isn’t ideal, but this strategy could help if you are in this unfortunate situation.

Some important factors to consider:

  • This will not help much if the fund kicks out a short-term capital gain as these are reported differently – they are considered ordinary income and thus capital losses do not directly offset them.
  • Selling a fund after a short holding period could result in some short-term trading penalties from your custodian or from the fund company itself. Check out these potential costs before trading.
  • Is there an opportunity here to get a long-term gain from the fund and lock in a short-term loss? No – the IRS saw this coming. See Pub. 564 “Capital gain distribution before short-term loss” for details and an example.

(Disclaimer: Check with your tax advisor before executing any strategies mentioned on this site.)

 

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CGV Basics – Don’t buy a tax headache!

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Dan just read “10 Mutual Funds You Must Buy Now!” in his favorite financial magazine. On Thursday, he invested $10,000 from his personal account into one of the funds from the article. On Friday, that fund made a capital gains distribution. In fact, the fund distributed 5% of its net asset value as a short-term capital gain and an additional 10% as a long-term capital gain. Due to this purchase, he’s added $1,500 in taxable income ($500 in ordinary income and $1,000 in long-term capital gain) to this year’s return. In his tax bracket, this cost him $410 in taxes even though he’s only owned the fund for one day. Tax headache!

What could Dan have done differently?

For starters, Dan probably should think twice before he follows the advice from these types of articles (remember Steve Forbes’ quote: “You make more money selling advice than following it.”) but I digress. More importantly, before making mutual fund investments at year-end, Dan should determine if and when the fund is going to make a distribution. Waiting until after the fund’s distribution “ex-date” would have saved him some money.

What options does Dan have if he really wants to purchase this fund? Here are several:

  • Bite the bullet and pay the taxes – These increase Dan’s cost basis and will result in less taxable gains in the future; this will eventually offset some of today’s pain.
  • Wait until the fund makes its distribution – This could result in lost gains if the holding does well while you’re waiting.
  • Make the purchase in a tax-deferred account – Investments made within IRAs, Roth IRAs, 401(k)s, etc. don’t have to worry about these issues.
  • Buy a similar holding – Index based exchange-traded funds (ETFs) might be a better option. ETFs can be incredibly tax-efficient; very few of them have ever made a capital gain distribution.

 

 

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CGV Basics – Beginners Should Start Here

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This site is designed primarily for educated investors. If you are new to the concept of capital gains and capital gains distributions, I’ve put together some FAQs below. If you are looking for a “starter” resource- check out the book “Common Sense on Mutual Funds” by John Bogle.

Q: What is a mutual fund capital gain distribution?

Simply put, a capital gain results when we buy low, then sell high. Capital losses are the opposite.

Mutual funds buy/sell holdings and (hopefully) create capital gains. Since mutual funds are not tax-paying entities- they are forced to distribute a substantial portion of these gains to their investors annually. Most mutual funds make these capital gains distributions in November or December of each year. For investors using mutual funds outside of tax-deferred accounts- it’s important to be aware of these distributions as they are considered taxable income.

Q: Are there any good primers on mutual fund taxation?

Yes! I really like the coverage that can be found at Fairmark.com’s Tax Guide on Mutual Fund Taxation.

Q: When can I ignore these distributions?

There are several situations where these capital gains distributions aren’t an issue (or a big issue):

  • you are very wealthy and enjoy paying taxes
  • you are investing funds in tax-deferred accounts (your IRA, Roth IRA, variable annuity, 401(k) plan, etc.)
  • you are making a small purchase or own a relatively small position – even a 20% distribution on a $500 purchase will only change this year’s taxes by $15-$35
  • you are in the lowest tax brackets and your fund is making long-term capital gains distributions (in some situations, these can be taxed at 0%)
  • you have loss carryforwards, and your fund is making long-term capital gains distributions

Q: How are these distributions taxed?

There are several types of mutual fund distributions and they each have different tax implications. Remember: these only matter in “taxable” accounts. The most common distributions are:

  • qualified dividends – these are taxed at preferential capital gains rates (0%, 15% or 20%)
  • ordinary dividends – these are taxed at your ordinary income rate (10%, 12%, 22%, 24%, 32%, 35%, 37%)
  • short-term capital gains – these are taxed at your ordinary income rate
  • long-term capital gains – these are taxed at preferential capital gains rate

For a more detailed overview, take a look at Fairmark.com’s Tax Guide on Mutual Funds.

Q: What are the key dates I need to pay attention to?

There are three key dates that apply to mutual fund distributions:

  • Record Date: If you own shares on this day then you are eligible to receive the distribution.
  • Ex-Dividend Date: The date when the distribution amount is deducted from the fund’s net asset value per share. Generally, this is the next business day after the record date.
  • Payment Date: Shareholders get their proportional shares on this date. This is typically the same business day as the ex-dividend date.

Q: I own the fund in my IRA; isn’t a huge distribution a good thing?

Capital gains distributions are economically neutral for tax-deferred investors. The key issue is that the fund will reduce its Net Asset Value (NAV) on the distribution date by the distribution amount.

Example 1: Chris owns $20,000 of ABC Fund in his IRA. The fund makes a 10% long-term capital gain distribution and Chris does not reinvest his distributions. The result: Chris’ account receives $2,000 in cash. He owns the same number of shares, but at a 10% reduction in NAV. He therefore has $2,000 plus $18,000 of ABC Fund.

Example 2: Chris owns $20,000 of ABC Fund in his IRA. The fund makes a 10% long-term capital gain distribution and Chris reinvests his distributions. The result: Chris’ $2,000 buys additional shares of the newly-discounted fund. He owns more shares; but since the NAV dropped by the same amount Chris still owns $20,000 of ABC Fund.

Q: I am reinvesting my dividends, am I taxed anyway?

Yes – taxes are due on distributed amounts no matter what you do with the proceeds.

Q: Do I need to worry about the wash sale rules?

Wash sale rules are a very important consideration when dealing with capital gains strategies. Basically, you are not allowed to claim a loss if you sell your holding at a loss and buy “substantially identical securities” within the 30 days before or after the sale. Fairmark.com’s Tax Guide on Wash Sales is an excellent source for additional information on this topic.

Q: How do I control future capital gains distributions?

Capital gains distributions are beyond the control of the shareholders. Actively managed mutual funds are typically the worst offenders when it comes to annual distributions. Even “tax-managed” funds and many of the more unusual index funds can make substantial fund distributions. To keep more of your gains in your pocket:

  • pay attention to capital gains distributions and make smart trades when these are substantial
  • think about your asset location (putting tax-inefficient funds in your IRAs and your tax-efficient holdings in your taxable account)
  • use market-cap weighted strategies (especially ETFs) as your core holdings in your taxable accounts, and perhaps as your only holdings in these accounts

 

 

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