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Mutual Funds And Capital Gains: Don’t Pay Someone Else’s Taxes!

Mutual Funds and Capital Gains: Don’t Pay Someone Else’s Taxes!

4 min read

With the end of the year quickly approaching, you may be focusing on potential opportunities to plan your 2014 tax situation. One important factor to consider: Year-end capital gains distributions paid by your mutual funds.

Capital gains are fundamentally a good thing. Anytime you or one of your mutual funds sells a stock for more than the original price, the result is a capital gain. However, you have an opportunity to do some tax planning whenever you can estimate a mutual fund’s capital gains. This is particularly important if you’re thinking of purchasing a fund near the end of the year.

Let’s take a moment to talk about the mechanics of capital-gains distributions. Funds earn investment income—including capital gains—all throughout the year. However, they often only pay out that income to investors at the end of the year. When this happens, the fund simply takes some of the cash it holds and sends it to investors in the form of dividends. The fund’s value then falls by an amount equal to the dividend.

Mutual funds are required to pay investors almost all of the investment income they produce every year—including that earned through capital gains. Investors who already own these mutual funds should be happy: Their fund has earned a return on its stocks and is now paying it out. On the other hand, there are some potential tax consequences to these distributions that investors need to consider.

When distributions are made in a taxable account, you may see an increase in your tax bill. Much the same way that data about our savings accounts goes to the Internal Revenue Service (IRS) and we’re then required to report our earned interest our tax returns, data on investment income paid by mutual funds gets reported to the IRS as well. There’s some good news here, though: You can sometimes avoid these distributions and potentially reduce your tax bill. Here’s one way to do it.

Mutual fund companies often compile estimates of their year-end distributions late in the year. If you’re looking to invest cash in a fund that’s about to pay a big distribution, beware: The fund pays its distribution on all of the income it has earned over the year to all of its account-holders. That includes you, even if you don’t buy into the fund until December. The result is that all of those capital gains that were earned starting back in January could wind up being taxable for you, a brand-new investor. In other words, you’re getting stuck with a tax bill for other investors’ capital gains!

One smart way to avoid this problem is to research capital gains estimates for funds you’re considering. If a fund you’d like to buy near the end of the year is about to pay a big distribution, delay your purchase for a few weeks. You can avoid the distribution and potentially pay less in taxes. This doesn’t mean you should keep your investment money in cash and run the risk of missing out on the market’s return over that period. You could instead buy an alternative fund with a similar investment strategy—one without a big distribution this year—while you wait.

Would it also be smart to sell funds that might pay big, taxable distributions? In some cases, yes. It’s important to consider the full tax picture here, though. If you sell the fund for more than you paid for it, you could still wind up with a big tax bill–one that’s even bigger than the tax bill for the distribution. However, if you sell a fund at a loss, you could use your proceeds to swap into an alternative fund for a short time.

At RegentAtlantic, looking out for large, taxable distributions and suggesting possible alternatives is an important part of our year-end planning process. We consult fund managers, research capital-gains estimates, evaluate the positions in our taxable accounts, and make trades to avoid distributions when possible and appropriate.

If you’re thinking about buying a new fund anytime soon, or you’re wondering how year-end distributions might affect your portfolio, feel free to check in with your Wealth Advisor.

 

Important Disclosure Information

Please remember that different types of investments involve varying degrees of risk, including the loss of money invested.  Past performance may not be indicative of future results. Therefore, it should not be assumed that future performance of any specific investment or investment strategy, including the investments or investment strategies recommended or undertaken by RegentAtlantic Capital, LLC (“RegentAtlantic”) will be profitable. Please remember to contact RegentAtlantic if there are any changes in your personal or financial situation or investment objectives for the purpose of reviewing our previous recommendations and services, or if you wish to impose, add, or modify any reasonable restrictions to our investment management services. A copy of our current written disclosure statement discussing our advisory services and fees is available for your review upon request. This article is not a substitute for personalized advice from RegentAtlantic.  This information is current only as of the date on which it was sent.  The statements and opinions expressed are, however, subject to change without notice based on market and other conditions and may differ from opinions expressed in other businesses and activities of RegentAtlantic.  Descriptions of RegentAtlantic’s process and strategies are based on general practice and we may make exceptions in specific cases.

Important disclosure information

Please remember that different types of investments involve varying degrees of risk, including the loss of money invested. Past performance may not be indicative of future results. Therefore, it should not be assumed that future performance of any specific investment or investment strategy, including the investments or investment strategies recommended or undertaken by RegentAtlantic Capital, LLC (“RegentAtlantic”) will be profitable.

Please remember to contact RegentAtlantic if there are any changes in your personal or financial situation or investment objectives for the purpose of reviewing our previous recommendations and services, or if you wish to impose, add, or modify any reasonable restrictions to our investment management services. A copy of our current written disclosure statement discussing our advisory services and fees is available for your review upon request.

This article is not a substitute for personalized advice from RegentAtlantic. This article is current only as of the date on which it was sent. The statements and opinions expressed are, however, subject to change without notice based on market and other conditions and may differ from opinions expressed in other businesses and activities of RegentAtlantic. Descriptions of RegentAtlantic’s process and strategies are based on general practice and we may make exceptions in specific cases.

RegentAtlantic does not provide legal or tax advice. Please consult with a legal and or tax professional of your choosing prior to implementing any of the strategies discussed in this article.

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