Even if it is too late to do anything about this year’s returns, it is a good time to start planning for next year’s. At the root of the most common blunders are three types of taxable fund payouts: interest income, dividends and capital gains. While all three are subject to a complex web of tax rates and regulations, investors can limit their tax bills by understanding their funds, planning carefully and staying abreast of tax changes in Washington. Here, according to financial advisers, are five of the biggest mistakes many fund investors make:
1. Keeping ‘tax-inefficient’ funds in a taxable brokerage account.
Some types of funds distribute lots of dividends, interest income and capital gains, all of which can boost tax bills. Many investors would be better off holding those funds in tax-sheltered retirement accounts. With a standard 401(k) plan or individual retirement account, you pay tax only when you make withdrawals; earnings and withdrawals usually are tax-free in a Roth 401(k) or Roth IRA.
Tax-efficient funds—those unlikely to make big distributions—can be left in a taxable account, says Michael Gibney, a financial adviser in Riverdale, N.J. You will owe capital-gains tax if you sell those securities at a gain, but at least the timing of such sales is under your control.
Taxable-bond funds, including high-yield funds and funds holding Treasury inflation-protected securities, are among the investments you might consider holding in an IRA, advisers say. Ditto for funds that emphasize high-dividend stocks. Meanwhile, index funds that track a broad stock-market benchmark—and most but not all ETFs—might be candidates for a taxable account, as would municipal bond funds, since interest earned is tax-free.
Determining whether a fund is going to have capital gains can be tricky. Each year, funds must distribute gains if portfolio managers sell securities for a net taxable gain. One indicator is the level of turnover in the portfolio, though, admittedly, it is an imprecise gauge.
The higher a fund’s turnover, a figure that can be found on Morningstar.com, the more likely it is to pay out capital gains, says Mark Armbruster, president of Armbruster Capital Management, which is in the Rochester, N.Y., area. If a fund has paid out capital gains in the past, something that also can be found on Morningstar, that also is a sign it may do so again, he says.
Small-stock funds may produce more capital gains than large-stock funds, advisers say, because there are many more small stocks to trade among.
Broad index funds, which don’t change their holdings very often, are less likely to pay out capital gains than some actively managed funds that change their investments based on market conditions. The Vanguard 500 Index fund, for example, has a 4% turnover ratio and hasn’t distributed capital gains since 1999. The actively managed CGM Focus, on the other hand, has a nearly 500% turnover rate. It has performed poorly in recent years, so it hasn’t been in a position to distribute gains, but it distributed $8.21 a share in mostly short-term capital gains in 2007.
Still, when and why a fund realizes capital gains is complex, so “turnover is only a very rough gauge of tax efficiency,” says Christine Benz, director of personal finance at Morningstar. Another gauge is Morningstar’s “potential capital-gains exposure” statistic, an estimate of the percentage of a fund’s assets that represent mostly unrealized gains.
ETFs, in particular, rarely distribute capital gains, Mr. Armbruster says. That is because most are index funds but also because they are structured to minimize taxable sales of portfolio securities.
2. Holding on to funds that cost you big.
Capital gains, whether taken on purpose by the investor or passed along by a fund, can add to your tax bill. But you can lessen their impact by strategically booking capital losses when holdings decline in value, so that they offset any gains dollar for dollar. In any year, if your capital losses exceed your capital gains, you can take up to $3,000 of the loss as a tax deduction and carry the rest of the loss forward to offset gains in future years.
This “tax-loss harvesting” has to be done carefully, however, to comply with Internal Revenue Service rules. Once you sell a fund or other security at a loss, you have to wait 30 days before buying either that same fund or a very similar fund (for instance, one that tracks the same index), or the loss is invalidated. “The securities cannot be ‘substantially identical,’ ” says Gil Charney, principal tax researcher at the Tax Institute at H&R Block, a division of H&R Block Inc., but “the IRS never clearly defined what substantially identical means.… It’s gray.”
If you want to keep exposure to the sector that fund covered, you can buy a slightly different fund—for instance, you likely could sell a fund tracking the Standard & Poor’s 500-stock index and immediately buy one tracking the Russell 1000, says Mr. Armbruster. You could later return to your original holding.
Keep tax-loss harvesting in mind any time the market or a particular holding suffers a major decline; you’ll miss opportunities if you think about this only near year-end.
3. Buying an ETF without learning what its tax treatment is.
Gains and income from certain ETFs are subject to funky tax rules because of the funds’ holdings or their corporate structures. Though most of these aberrations invest in niche industries, some of the most popular ETFs could leave you with a surprisingly large tax bill.
The most popular offender: Gains from selling SPDR Gold Shares, the second-largest exchange-traded product by assets, are taxed at a top 28% rate on collectibles, rather than the maximum 15% rate on long-term capital gains. That is true for all other funds that hold physical precious metals.
There are different rules for ETFs that provide commodities exposure by investing in futures contracts: Gains are taxed 60% at a long-term rate and 40% at a short-term rate. ETFs structured this way include some from the U.S. Commodity, PowerShares and ProShares families.
Also, some non-stock ETFs are structured as partnerships and report their tax information on a Schedule K-1 instead of the common 1099 form. Schedule K-1 typically is sent later than a 1099—it may not even arrive before your tax return is due because the partnership has to file its own return before sending you this form, says Eric Smith, an IRS spokesman. In this situation, you’ll want to ask for an extension from the IRS, he says. You can avoid these hassles by holding these funds in an IRA.
4. Fudging the new forms.
Reporting securities sales on your tax return has gotten more complex, with new rules that require brokerage firms and fund companies to report to the IRS what you paid for some securities you sell. Because that reporting applies only to securities purchased after specified dates, you may have sales of both “covered” and non-covered assets. As in the past, for non-covered securities, the financial firm may voluntarily provide cost information only to you.
The new rules could make tax preparation more complex, tripping up some investors.
“Basically what they’ve done is taken Schedule D and added a new schedule behind it—Form 8949. All the transactions you used to put directly on Schedule D…are now on this new form,” says Robert Schmansky, a financial adviser in Bloomfield Hills, Mich.
The most important thing to know about Form 8949 is that you will have to separate the covered transactions from those that aren’t and report them on different lines. Individual stocks purchased on or after Jan. 1, 2011, are covered; for mutual funds and most ETFs, the new treatment applies to purchases on or after Jan. 1, 2012. Then, you must add the covered and non-covered transactions and put the total on Schedule D.
5. Investing without paying attention to the tax debate in Washington.
When deciding when to take gains and what account to hold various funds in, it is important to stay abreast of what is going on in Washington.
Think hard about where tax rates are likely headed in the future. While some tax changes affecting funds are already in store, some experts watching the political debate—and the ballooning federal deficit—say investors may want to hedge their bets against higher rates and pay taxes on their gains soon.
There are a number of big tax changes on tap starting in 2013 that could deal a huge blow to your funds. If the Bush tax cuts are allowed to expire, the top rate on ordinary income and short-term capital gains will rise to 39.6% from 35%.
The current top 15% rate on long-term capital gains is set to rise to 20%. Qualified dividends will no longer be taxed at a top 15% rate and will be taxed as ordinary income. Also, net investment income, which includes dividends, interest and capital gains, will be subject to a new 3.8% Medicare tax, part of the Affordable Care Act, for married couples filing jointly who earn more than $250,000 a year and individuals earning more than $200,000 a year…
If you think that your tax rate on capital gains will rise soon, you may want to book a capital gain this year to lock in the 15% rate. Unlike with a capital loss, if you’re booking a gain you can repurchase the same exact fund in any quantity immediately after selling it.
Figuring the ins and outs of tax pitfalls for funds is a very complex process. Contact an R&G Brenner professional to help you navigate these tricky tax waters.
Source: The Wall Street Journal