CGV Intermediate – Keeping More of What You Make

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.



photo credit: 401(K) 2013 via photopin cc