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!