With barely two months left in the year, experts say it’s time for investors to tidy their affairs with moves to trim tax bills — a particular challenge this year due to the stock market’s big gains.
Investors, for example, should avoid inheriting a tax burden by purchasing shares of mutual funds likely to have big year-end capital gains distributions.
“After several years of up markets, it’s very likely some funds will have large year-end capital gain distributions this year,” says Anthony D. Criscuolo, portfolio manager with Palisades Hudson Financial Group in Fort Lauderdale, Florida. “Investors should look for published guidance for the amount and timing of these year-end distributions and avoid buying into a fund that will make a large distribution.”
Federal law requires that gains from assets the fund sold during the year be paid to shareholders by year-end, and these payouts are taxed as long- or short-term capital gains if the fund is in a taxable account, even if you have them reinvested immediately and never receive the cash.
[See: 8 Boring Stocks With Soaring Potential.]
The problem is that those profits are reflected in the fund share price before the distributions are made, and, all else being equal, after the payout the share price falls because this cash is no longer among its holdings. The investor is therefore no richer the day after the payout than the day before, afterward owning shares worth less, plus the cash payout or new shares bought with the payout. But the investor will face a tax on the distribution unless the fund is held in an individual retirement account, 401(k) or similar tax-favored account.
It’s impossible to know what a fund’s payout will be until the managers announce it. The payout reflects results through Oct. 31, but managers may offset big gains with losses booked during the year or carried forward from previous years.
“Many active managers for stocks had a stellar 2017 but a mediocre 2016, so there may be more offsetting losses still,” says Zachary Karabell, head of global strategies at Envestnet, a Chicago provider of wealth management technology and services to investment advisors.
It’s possible, then, that one fund will have a large payout while another with similar performance that was able to book losses will pay less.
Investing experts often recommend avoiding last-minute purchase of funds likely to have big distributions. Buying after the payout allows you to avoid the distribution and subsequent tax bill, and the shares should be cheaper. A fund’s history of payouts can be a guide but not a guarantee, since the payout is not set until November or December.
“If you do want to buy into a fund, wait until after the record date, not the pay date, to buy into the fund,” Criscuolo says. “The record date is that date which counts for who actually gets the distribution, and it is usually a few days before the distribution is actually paid out.”
Record dates, pay dates and distribution amounts are listed on fund websites, often beginning in November, though the amount can change.
The biggest payouts are usually made by actively managed funds that have enjoyed large gains, since managers may sell winning holdings to lock in gains to assure year-end results look good. Index-style funds generally have very small distributions, if any, because of their buy-and-hold investing style. Most exchange-traded funds have no distributions since they, too, use indexing and are designed to include all gains in the share price.
Of course, postponing an investment in a promising fund can mean missing out on gains in the meantime. So, if you’re yearning to get into a fund likely to have a big payout, consider buying it in an IRA or 401(k), so the distribution will not be taxed immediately.
Also look at the fund data to determine how much of the distribution will be short-term capital gains — for assets the fund had owned for 12 months or less. Those will be taxed at income tax rates that are generally higher than the rate for long-term capital gains. If the short-term gains will be substantial, you can avoid them by selling the fund before the record date. You may well be taxed on your gains from the fund shares, but that would be at the lower long-term rate if you’d had the shares longer than a year.
[See: 10 ETFs to Buy for Oodles of Growth.]
To avoid this problem in the future, considering switching to a fund not likely to have large distributions. Some managed funds, for instance, minimize distributions with strategies like selling losing investments to offset winners and timing sales to get the long-term tax rate rather than the short-term rate.
“Depending on goals, some investors and their advisors will, of course, prefer tax-managed funds, especially for conservative portfolios that have a fairly modest absolute return,” Karabell says. “There, taxes can be the difference between meeting financial goals and falling short.”
Many managed funds don’t use these strategies, however, because such moves boost trading costs, and because most of the fund’s shares may be held in retirement accounts that defer taxes anyway until money is withdrawn.
Index products tend to have very small distributions, or none at all, because they don’t sell winning holdings unless they have to raise cash for investor redemptions, which are more likely in a down market than a rising one. ETFs generally have no distributions.
So, if you’re repeatedly hit with big tax bills for year-end payouts from managed funds, consider switching to an indexed product that owns the same type of stock — large cap, small cap, foreign and so forth.
“If you are able to sell and avoid the gain, you can look to purchase an index fund that has similar market exposure as to the fund you are selling,” Criscuolo says. “This ensures you remain fully invested in the asset class you desire.”
David S. Hunter, a planner with Horizons Wealth Management in Asheville, North Carolina, says he prefers ETFs because distributions from managed funds are so unpredictable.
“We have shifted to entirely ETFs, which eliminates 99 percent of fund distributions,” he says. This allows the investor or advisor to decide when to book taxable gains, since gains are realized only when ETF shares are sold, he says.
[See: 7 Best Dividend Stocks to Buy for the Rest of 2017.]
“By putting the power of realizing gains back into our hands, we can more effectively rebalance when necessary,” Hunter says.
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How to Avoid Year-End Fund Distributions originally appeared on usnews.com
