It's Time to Start Your Year-End Tax Planning - Rodgers & Associates
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It’s Time to Start Your Year-End Tax Planning

Tax Planning

The fourth quarter marks the beginning of year-end tax planning. A good place to start is to avoid unpleasant surprises from newly purchased mutual funds. Investment research of a new fund for a taxable account should include the potential for year-end distri­b­u­tions which are taxable to the fund owner regardless of how long they’ve owned the fund.

Most mutual funds save distri­b­u­tions of capital gains and dividend income until the end of the year in the event they can offset some of it with unrealized losses. Mutual funds are not required to do this unless they identify themselves as a tax efficient fund. It just makes sense to hold payouts until the end of the year when they are required to distribute. Funds are required to distribute 95% of their net income and capital gains.

Any distri­b­u­tions are taxable to the fund’s owner if it is held in a taxable account. The wise investor will research the date a fund has scheduled a distri­b­ution to avoid buying the fund before the decla­ration date. Not only is the distri­b­ution taxable but the share price will be adjusted down by the amount of the dividend resulting in an unrealized loss of the shares just purchased.

To avoid this common year-end tax trap, check for potential unrealized gains in a fund by going to the fund’s website and researching potential capital gains exposure. Some funds still hold loss carry forwards from the 2008–2009 stock market drop. Gains earned in recent years are sheltered by the earlier losses which avoids the need to make a capital gain distri­b­ution. Check for distri­b­ution estimates while on the website. Many funds start to post this infor­mation in October to alert investors of distri­b­u­tions likely to be declared during this tax year. “Record dates” and “distri­b­ution dates” from earlier years will also help identify when the mutual fund usually pays its dividends. Not all funds wait until the end of December to make these payments.

The final piece of the puzzle is the size of the expected distri­b­ution. A small distri­b­ution may not be worth waiting to avoid. Your personal tax return may also contain capital loss carry forwards which will offset a small capital gain distri­b­ution. Waiting to invest in a stock fund to avoid a small distri­b­ution doesn’t make sense if the stock market moves up while you’re waiting.

The second part of tax planning around mutual fund distri­b­u­tions involves the mutual funds already held.  An investor should consider whether it makes sense to sell a fund they own if they know a large distri­b­ution is being declared. Would the tax liability be higher if the fund was held and the distri­b­ution collected, or if the fund was sold and the distri­b­ution avoided? Start by deter­mining what the gain would be on the fund if it was sold and whether it would be long-term or short-term. You should also check if the fund has a short-term redemption charge. Finally, how has the fund performed? The position may be a questionable hold regardless of the tax impli­ca­tions. This might be the deter­mining factor to tip the decision in favor of an outright sell.

There are some who believe tax mitigation strategies should be avoided because the increased cost of trading will negate any tax benefits. Avoiding mutual fund distri­b­u­tions, harvesting unrealized losses and other strategies all carry potential costs either from trading or being out of the market at the wrong time. There may be some merit to this which is why tax mitigation should also include perfor­mance evalu­ation of the position. Use tax strategies in combi­nation with upgrading positions to align with the current market leaders and rebalance the overall portfolio. Upgrading can be tax efficient by gener­ating primarily long term gains which are taxed at a lower rate than short term gains.

Keep in mind paying taxes now is not neces­sarily bad when you control the amount to minimize the rate of tax paid. Tax rates may or may not be lower in the future. A smart overall tax strategy should defer some but not all tax liability to avoid the risk of paying tax at a higher rate in the future.

Rick’s Tips:

  • Start your year-end tax planning by avoiding the potential tax trap of investing in a fund before they distribute capital gains.
  • Research your own funds to see if any of them plan to make large distri­b­u­tions.
  • Evaluate the tax impli­ca­tions of selling a fund before distri­b­u­tions are declared.