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How to (Potentially) Neutralize Your Coming Mutual Fund Tax Bill

If you own actively managed mutual funds in taxable accounts (something we don’t normally recommend), you may have an unpleasant surprise brewing: a big capital-gains tax hit when your funds make their annual distributions (usually in December). A particularly unpleasant feature of being a mutual fund shareholder in a taxable account is that you get to pay your share of the fund’s tax liability every year even if you did not sell any shares during that year!

Furthermore, two trends are colliding which could make the 2019 capital gains tax distribution season much worse than average for many funds.

First, there is a massive shift of money underway as investors have gotten wise to the tax drawbacks of high-turnover mutual funds and are leaving them for lower-cost, tax-friendly exchange-traded funds (ETFs). As an investor pulls money from a mutual fund, the fund’s portfolio manager is forced to sell assets to raise cash to meet redemption requests.  These asset sales are taxable events which may generate short- or long-term capital gains, upon which fund shareholders must pay tax. And as mutual funds bleed assets, the remaining shareholders will be holding an increasingly large share of the funds’ taxable distributions to come in the future.

Second, U.S. stocks have performed well in 2019 after a dismal end to 2018. This means that fund managers may not have a lot of losses in their funds that they can use to offset the capital gains they are taking. In the wake of the 2008-09 financial crisis, many funds had lots of unrealized losses that they were able to use over the succeeding years to offset capital gains. However, this pool of potential losses has become much smaller as time has passed since the crisis, giving fund managers fewer options for offsetting gains.

What Can You Do?

It is always worth it to do what is allowable in the tax code to reduce your tax liability, for once you fork your cash over to the IRS (or to your state’s treasury) that money leaves your world forever. Best to do what you can to keep that money in-house, working for you. If you will be facing taxes on capital gains distributions for 2019, there is something you can (potentially) do to ease the pain: do some tax-loss harvesting.

Tax-loss harvesting is just one of many useful tax-mitigation strategies. It works like this:

  • An investor sells investments with losses to offset the capital gains distributed by his or her funds. Any amount of capital gain can be offset, provided the losses are there.
  • Individuals are permitted to write off $3,000 of capital losses against their taxable income above and beyond the losses used to offset gains. In broad terms, if you can show a net realized capital loss of $3,000, you can usually save from $500 to $1200 in taxes, depending on your tax bracket. (If your net losses are greater than $3,000, they can be carried forward to the next tax year.)
  • After selling a losing position and realizing a capital loss, the investor can immediately invest the proceeds back into a similar asset to keep his or her investment exposure consistent.
  • The trick here is that the loss cannot be claimed if the proceeds are reinvested within 30 days of the original sale back into what the IRS considers to be a “substantially identical asset.”

Tax-loss harvesting is a useful strategy, but not all investors take advantage of it assiduously. At this moment, with U.S. large-cap stocks near their highs, investors may need to look to their international or small-cap funds for potential losses.

By our way of thinking, effective wealth management means taking advantage of the many, many small opportunities to make incremental improvements in one’s financial situation every year. Over time, these many small improvements will compound into a major improvement.Financial Planning

If you would like our thoughts on how you might reduce your tax bill by employing prudent strategies and tactics such as tax-loss harvesting, please don’t hesitate to give us a call or send us an email.

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Picture of Peter Thoms, CFA, MBA

Peter Thoms, CFA, MBA

Peter Thoms, CFA, founded Orion Capital Management LLC in April 2002. Peter has extensive experience managing investment portfolios for clients pursuing a wide range of financial goals.

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