7 year-end tax tips for mutual fund investors
Wed Nov 23, 8:02 pm
BOSTON (AP) — A surge of cashflow into a business can make it seem like a powerhouse. Yet its bottom line might be underwhelming after taxes and other expenses are figured in.
The same can hold true with investing. Enthusiasm about market-beating performance touted in a quarterly mutual fund report can wither once an investor's after-tax return is calculated.
The gap between pre- and post-tax returns isn't an issue for mutual funds held in retirement accounts such as IRAs or 401(k)s, where investment earnings can grow tax-free. But the difference can be significant for funds held outside a tax-sheltered account, especially for an investor in a high tax bracket.
It's an especially timely consideration as the year draws to a close. In November and December, investors with taxable accounts should stay alert to disclosures about any capital gains distributions that mutual funds expect to make to their investors. A distribution may sound like a gift, but it's not — it's a gain that Uncle Sam considers taxable income.
Still, investors can limit their tax exposure with savvy end-of-year moves, on their own or with the help of professional advisers.
Investors can take some comfort in the stock market's lousy 2011 performance. The nearly 6 percent decline of the Standard & Poor's 500 index won't help investors meet long-term savings goals. But it does mean that relatively few stock funds have capital gains to pass on to investors. Foreign stocks have fared worse, so investors are even less likely to see tax bills from the international portion of their fund portfolios.
"There aren't many people who will have to worry about big capital gains this year," says Cliff Caplan, a financial planner and president of Neponset Valley Financial Partners in Norwood, Mass. "To the extent that there will be gains, they're going to be in taxable bonds."
Diversified bond funds have returned an average of 2 percent this year, according to Morningstar. That makes taxable bonds — a category that excludes municipal bonds, whose investors are exempt from federal taxes — a logical place to begin when scrutinizing a fund portfolio for potential hidden tax hits.
But don't ignore the stock component. Dividend-paying stocks have generally fared better than the broader market, making them potential candidates to pass on capital gains. And stocks have been unusually volatile this year, which creates an opportunity for fund managers who frequently trade holdings in hopes of beating the market. If they succeed, an investor can get ahead. But the advantage could be minimal if an investor gets hit with capital gains.
Here are 7 tips and current considerations to make about mutual funds and limiting tax exposure:
1. Understand capital gains: When fund managers sell stocks or bonds that appreciated in value, they pass on the capital gains to investors each year. It can happen even if a mutual fund lost money. That's because it's the appreciation of the fund's individual holdings, rather than of the fund as a whole, that trigger capital gains.
2. Check the estimates: Fund companies are now giving investors a heads-up about which mutual funds they expect will generate short-term capital gains by the end of December. For the latest details, check your fund company's website, or call. Keep in mind that current distribution information is an estimate, typically based on fund performance through the end of October. Things can change over the final two months of the year.
3. Consider timing: If a fund expects to distribute a gain, wait until after the distribution date to invest any new cash in that fund, if it will be held in a taxable account. If you don't, you could get hit with a tax bill covering gains that you didn't share in, because they occurred before you invested.
4. Get the long-term picture: Stock fund investors can still get hit with distributions, despite this year's market decline. That's because some funds still have long-term gains on their books from 2009 and 2010 that haven't yet been paid out to shareholders. Stocks rallied strongly both those years. Morningstar found earlier this month that about half of the stock funds it tracks have potential long-term capital gains exposure. A long-term gain is anything earned from holding an investment for more than a year. The distinction versus short-term gains is crucial, because the tax treatment is different. It's most important to avoid short-term gains, because they're taxed at ordinary income rates up to 35 percent. Long-term gains are taxed at just 5 percent for taxpayers in lower-income brackets, to 15 percent for those in higher brackets.
5. Consider taking tax losses: To offset any capital gains elsewhere in a portfolio, investors might want to consider selling some of the investments in their taxable accounts that have lost value. Under current tax law, a capital loss deduction allows an investor to claim up to $3,000 more in losses than in capital gains. That means investors can reduce their taxable income dollar for dollar, up to that $3,000 limit. (The limit is $1,500 for a taxpayer who's married, and files separately.)
6. Be patient getting back in: If you want to quickly get back into a mutual fund or a stock after selling it at a loss, you should know about the "wash sale" rule. The loss can't be deducted unless an investor waits at least 30 days to re-invest in that same investment.
7. Take advantage of low rates: Tax rates are historically low now, due to the Bush-era tax cuts that Congress and President Obama extended through 2012 in a deal reached last December. For example, the agreement keeps the long-term capital gains rate at 15 percent. But that rate could rise starting in 2013 unless Congress extends it further. The Bush tax cuts also mean that investors benefit from an extension of the historically low rates on dividend income, which top out at 15 percent. Without the extension, dividend payments would have been taxed as regular income, raising the rate to as much as 39.6 percent for top earners. Many experts expect the low rates can't continue beyond 2012, if the government is to generate the tax revenue needed to get the budget deficit under control.
Questions? E-mail investorinsight(at)ap.org