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4 Signs Your Mutual Fund is A Tax Migraine About to Happen

4 Signs Your Mutual Fund is A Tax Migraine About to Happen

| June 07, 2018
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Mutual funds are viewed as an easy and safe place to park your money. What most people don’t realize, however, is that mutual funds are intrinsically designed for tax inefficiency. Watch out for these four signals that you're about to get hit with a tax migraine.

Where the Accounting Profession Fails People

Taxes are the biggest drain on wealth that most people will experience in their lives. However that’s not surprising, given how most accountants neglect the taxes their clients face on their investments.

The typical person holds investments in their accounts and looks at them every so often, let’s say every month. And what do you focus on? Let’s be honest. It’s one thing and one thing only.

The return.

And this is a pre-tax return you are looking at. So even though you may be pleased with what you see, you’re not looking at the real number net of taxes.

The tax bill doesn’t come until February or March and at that point, you’re not thinking about your portfolio. You sit down with your accountant and look at the 1099 form that the investment company sends you, and your accountant tells you how much tax you owe the IRS.

And then your accountant talks about what you can do to minimize this next year? Right?

Or…not.

It’s common for the accountant not to do so, for timing reasons. Tax preparation is increasingly becoming a commoditized business. Most accountants are overworked and barely have enough time to get through the high volume of returns they need to process just to get by.  You’re looking at this during a time crunch. It’s unlikely your accountant will take the time to discuss tax planning at this point.

Because investment returns and tax cost are never really looked at side by side, it’s never clear to people what their investments are really costing them in taxes.  A good accountant will call this to your attention, but the reality is that most will push it off until later and it ends up never happening.

Signal #1 Too Much Turnover

Turnover is generally a bad thing for your tax bill.

When a portfolio manager sells a security, the shares realize gains. These gains apply to all shareholders, regardless of whether you’ve held the shares since the position was initiated (and have enjoyed the run up of their share price) or just bought shares yesterday (experiencing very little, if any, of the gain for yourself).

Now here’s where it gets dicey.

The portfolio manager only cares about the performance of the fund; your tax bill isn’t even on the radar screen. This view is shared by the fund management company as well; they’ll hire or fire managers based only on performance. When a new manager comes on, expect high turnover as they’ll clean house of all positions that don’t jive with their take on the markets.

Did you have any capital gain distributions in 2017?  They would appear on the Schedule D of your tax return on line 13.

Signal #2 Income Distributions

Mutual funds are pass-through investments, meaning that they have to pass through any income earned to the shareholders instead of investing them back into the fund. These distributions are taxable each year to shareholders.

What are some signs you’re likely to be hit with tax on income distributions?

  • Your fund does excessive trading and incurs capital gains 
  • Your fund distributes nonqualified dividends. Payors of non-qualified dividends include REITs, MLPs and dividends on savings or money market accounts and certain foreign corporations. 
  • Nonqualified dividends do not receive preferential tax treatment like qualified dividends.

Signal #3 Holding Out of State or Private Bonds

Bonds are viewed as a less risky investment and for that reason most people don’t think twice about them. But in reality, bonds come with a slew of tax implications.

Holding out of state bonds causes you to pay additional income tax to your home state. Deducting this additional tax is capped to $10,000 under the new law.  Also, if the bonds are private purpose (a municipal bond with 10% or more of proceeds funding the private sector), the interest may subject you to Alternative Minimum Tax.

Signal #4 Shareholder Redemptions

The fund may be forced, through no fault of its own, to sell positions to pay out existing shareholders exiting the fund. For example, large pension funds like CalPERS tend to hold stakes in some of the larger mutual funds. As baby boomers retire in droves, the result will be high levels of redemptions from 401k and 403b plans whose main holdings are mutual funds.

Avoiding a Tax Migraine Before It Starts

Most people hold mutual funds because of how they were sold. Because particular classes of mutual funds offer a handsome commission, or load, to the seller, they are often recommended to fulfill an asset allocation.

We’re going to talk about some money moves that will help, but before we do that, let’s talk about people.

The person making your investment decisions plays a huge role in how tax sensitive your portfolio is. Working with a financial advisor who gets paid a fee for assets under management rather than a commission for recommendations may be less likely to suggest mutual funds.

Take a look at your financial statements. Do you see any “A shares” funds? It’s possible these were suggested for that reason.

Also consider working with an advisor who is also a CPA. The advantage is that tax sensitivity is built into the process on an ongoing basis.  An advisor who is also a CPA will likely have a deep knowledge of how to:

  • Purchase tax-free (or low taxed) investments such as municipal bonds that won’t create AMT.
  • Avoid or limit income-generating assets, such as taxable interest-paying bonds. If these are held, place them into a qualified plan where all distributions are taxed at ordinary tax rates anyway.
  • Invest in mutual funds that keep turnover low.
  • Use ETFs that track an index rather than trade stocks actively.
  • Find appropriate tax-managed mutual funds which are designed to limit distributions of income and capital gains. Shareholders will owe little or no tax until they sell their shares of the fund itself.
  • Hold your funds in a separately managed account in which you, not a portfolio manager, will control the buying and selling.

The After Tax Return Is What Matters

It’s not what you earn, it’s what stays with you after taxes that counts. At Abbondandolo Wealth Management, we’re a fee-only RIA firm and every single advisor with our firm is a CPA. Contact us to put the tax migraine to an end by applying a tax management overlay strategy to your portfolio.

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