Some mutual funds inflict great damage on your 1040. Stand up for yourself.
By William BaldwinMain contributor
WInter: the season in which fund owners suffer self-inflicted injuries.
Investors who make the mistake of holding stock mutual funds in taxable accounts risk receiving unwanted distributions. This often happens in December. They pay the price the following April.
Concrete example: the JP Morgan Tax Aware Equity fund. The name says it will be kind to taxpayers. The reality is different. The fund admitted that a large, taxable capital gains distribution would arrive before the end of the year.
If you hold this fund anywhere other than a tax-sheltered account, you will share part of your investment with the tax collector. The payment will be 21.4% of your account, and you will pay federal tax on the distribution, at a rate of up to 23.8%. State income taxes lead.
Money sellers often telegraph their moves. This table shows other funds that have warned shareholders of impending damage.
PREPARE YOURSELVES
Holders of one of these investment companies will benefit from a capital gain distribution for 2023, whether they like it or not.
Sometimes there’s nothing you can do about it. If you have owned one of these funds for a long time, resistance is futile.
Let’s say you entered a fund years ago at $20, saw its portfolio appreciate to $25 per fund share, and notice that a $5 capital gains distribution is now in progress. If you stick with it, you’ll have a $5 capital gain distribution to report. If you flee before payment, you will have the same $5 long-term gain to report.
How do the funds end up in this situation? By selling portfolio positions at a profit. This can happen in two ways.
The first would be for a trigger-happy portfolio manager to sell winning stocks in order to reinvest in something more attractive. Presumably, a “tax conscious” fund will avoid such behavior. But most funds are rather nonchalant when it comes to taxes.
The other cause of unwanted payments is redemptions. When clients leave, the manager is forced to liquidate his assets to collect them. If there are no more losers, he sells appreciated stocks. Once the fund has exhausted any loss carryovers, it is obligated to distribute gains on those shares to the shrinking group of surviving shareholders. Among the victims are latecomers who are underwater on their fund shares.
There are preventatives and antidotes. Consider these six strategies.
1. Location your investments wisely.
An actively managed stock fund should be placed in your account tax-free. If there’s no room for it, don’t buy it.
2. Getting out of weak funds.
Let’s say, in our example, you entered the fund at $24 and it then declares a dividend of $5. You can sell before payment and report a gain of $1. Or you could sell afterwards, getting a $5 dividend offset by a $4 loss on the fund’s share, for the same long-term net gain of $1 to pay tax on. It doesn’t matter whether you exit before or after the dividend. The key here: The fund’s ex-dividend price, $20, is lower than your purchase price, $24.
3. Look before you invest.
Morningstar reports a “tax cost ratio” for funds that have been around for a while. It’s based on past distributions, but it’s a pretty good indication of the problems a fund will cause you in the future.
Among funds that hold only U.S. stocks or a mix of stocks and bonds, here are the worst offenders:
TAX CHARGES ON FUNDS: THE WORST
These funds create enormous tax damage with their distributions. Their expense ratios aren’t a bargain either.
The tax cost ratio is defined as the average annual percentage loss in federal income taxes for those in the higher brackets. So, if in one year a fund had turned your $100 into $130 in a tax-free account but only $117 in a taxable account, it would have a cost ratio of 10%.
Access the ratio by selecting the “performance” tab of Morningstar then clicking on “end of month”.
Morningstar’s calculation does not reflect the capital gain (or loss) that would occur on a sale of fund shares. It doesn’t include state income tax or the many ways a distribution can boomerang your return by increasing your adjusted gross income. For many investors, even those not in the upper brackets, this underestimates the erosion of income taxes.
The sinner’s table is limited to domestic stock funds that have been around for a decade, have not kept pace with the overall stock market before taxes, and have generated a tax cost of at least 5% per year. Really bad apples.
But note that there are many slightly rotten apples that could not be exposed. A reasonable forecast for the real return on stocks – a return above inflation – is 4% per year. A poorly generated fund erases this return.
4. Consider creating a “tax-focused” fund.
But only if it’s cheap.
Here is a catalog of stocks and balanced funds with “tax” in the name. The Vanguard ones are good buys. Most of the rest should be avoided.
TAX MANAGED FUNDS
These equity and balanced mutual funds aim to keep your taxes low – and sometimes only achieve this by incurring high expenses. For comparison: an iShares exchange-traded fund, which doesn’t advertise any special efforts to minimize taxes, but nonetheless does so simply by dint of being an ETF.
It turns out that one way to achieve a low tax cost ratio is to defraud shareholders. Expenses are deducted from the top, reducing the taxable income that must be distributed. Pay attention to the combined cost of ownership: taxes plus expenses.
5. Crop losses.
Whether or not you are affected by capital gains distributions, loss harvesting is good financial hygiene. Capital losses and loss carryforwards can offset many things, such as the gain from the sale of a home.
The idea is to sell a losing position, stay out for 31 days, then buy it back. While you’re on the sidelines, protect yourself against a rebound by temporarily holding back a substitute.
If you lost money on Exxon Mobil, you would immediately sell and buy Chevron, then reverse the trades a month later, assuming Exxon is the stock you would prefer to own. If you held both and lost money on both, you would sell Exxon, double the Chevron, and after a month sell the more expensive Chevron shares and reestablish the Exxon position. You can also maintain your place in the oil sector by temporarily investing in the Fidelity MSCI Energy Exchange-Traded Fund.
6. Prefer ETFs.
There are two reasons why an exchange-traded fund is the only type of stock fund to hold in a taxable account. The first is that most ETFs track indexes, so there’s no reason for them to reshuffle their portfolios. The other is that they can use a special loophole, involving trading securities with ETF market makers, that causes capital gains to disappear. Mutual funds cannot easily exploit this loophole. There are cases where equity ETFs are forced to give back their gains – the iShares Taiwan fund shown in the first table above is one example – but they are quite rare.
Bottom line: Given all the ways to avoid this, you only have yourself to blame for the discomfort caused by capitalization dividends.
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