The end of the year is a great time to review your holistic financial picture and take inventory of where you are financially.
Taxes are one of the areas that deserve attention because taxes touch so many areas of financial life. Many investors fail to recognize the tax cost, or drag, associated with investing in mutual funds.
The bottom line is that taxes are a form of expense just like any fee, and they eat into your return.
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Mutual funds are structured so that at least 95% of their net gains during the calendar year are passed through to the mutual fund's shareholders in the form of distributions. As such, if a distribution occurs in December, you would be subject to full taxation even though you may have bought the mutual fund only a few weeks earlier.
Some investors believe these distributions mean they are being paid by the mutual fund. The reality is that a distribution is nothing more than stocks or bonds being sold by the mutual fund manager and the net capital gain being taxable to you.
The price or net asset value of the mutual fund will decrease by exactly the amount of the distribution; therefore, the total value of your fund does not increase, just the amount in taxes you might have to pay this year.
Many investors reinvest the distribution, thus paying the tax from other sources.
To take inventory, investors should begin by looking at the mutual fund holdings in their taxable account one by one.
By searching the mutual fund ticker symbol on Morningstar.com, investors can view their potential capital gains exposure for a specific fund. This will give them an idea of what the embedded capital gain is in the mutual fund they own or are considering buying.
The reason that knowing the embedded capital gain is important is it will give investors an idea of their potential tax exposure in any given year.
For example, if a mutual fund has an embedded capital gain of 40%, and the manager were to liquidate the entire portfolio, 40% of the investment will be taxed as a capital gain. While unlikely to happen, it illustrates the concept.
Another important thing to consider is the turnover ratio of the fund. The turnover ratio is the percentage of the portfolio that is sold on average each year. In general, a high turnover within the fund (the more active the portfolio manager), coupled with a high embedded capital gain exposure, could lead to a large capital gain distribution in any given year.
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The tax expense can be as high as the mutual fund expense ratio itself, in some cases.
The other issue that it presents is the lack of control the investor has over when they are subject to capital gains taxes. A large capital gains distribution could coincide with a high wage-earning year, resulting in a higher capital gains tax rate and a potential net investment income tax.
Importantly, if you are looking to buy an actively managed fund, consider buying it inside a retirement account, like an IRA, to avoid tax consequences.
While this does not mean that you should never buy an actively managed mutual fund outside your retirement accounts, you should be aware of how taxes effect your mutual fund return, and whether investing in another way might make more sense.
One alternative to buying actively managed mutual funds is purchasing index mutual funds or index exchange traded funds. Index funds have very low turnover, resulting in a minimal yearly tax expense.
Another alternative is to purchase individual stocks where you can control the buying and selling and intentionally offset gains with losses to minimize taxes. This approach requires more sophistication, vigilance and monitoring than purchasing mutual funds, generally with less diversification.
You may be in a situation where you have owned a mutual fund for many years and have large embedded capital gains in the position itself. The mutual fund may be distributing large capital gains year after year and your only way out is to sell the mutual fund.
If this is the case, you may want to consider waiting until the year after you retire when your taxable income is lower to sell these funds and minimize the tax bite as much as possible.
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Another tax planning opportunity would be to gift the mutual fund to a charity or donor-advised fund. In doing so, you would avoid the capital gain tax and receive a deduction for the market value of the donation if you itemize your taxes in that year.