The holidays are here! For mutual fund holders, that means it is time to fill your investment stockings with taxable dividends and capital gains! That’s because at year-end, many publicly traded companies pay out excess earnings to their shareholders in the form of dividends. For mutual funds companies, often these dividends are aggregated throughout the year and paid out at least once annually, often falling towards the end of the calendar year.
Mutual fund holders can choose to receive their dividends as cash within their accounts. At such time, the share price of the associated mutual fund drops temporarily. In lieu of a cash dividend, mutual fund shareholders can elect to have dividends reinvested, or used to purchase more shares of the same mutual fund. Reinvestment is a low cost and efficient way to increase the value of a stock, mutual fund, or exchange traded fund (ETF) over time.
Throughout the year, mutual fund managers may sell some of the stocks within the fund at a profit. These profits are passed through to the shareholders at year-end. If the original investment was held for less than a year, the gain is taxable as short-term capital gain to the investor. If the original investment was held for longer than a year, the gain is taxable as long-term capital gain. Generally, short-term capital gain is taxed at a higher rate than long-term capital gain, and therefore long-term capital gain is preferred.
These transactions often go unnoticed by the original investment holder because the sale happens within the mutual fund itself, even if the shareholder does not sell any of their mutual fund investment. Therefore, mutual fund investors are often only aware of the taxable implications after the transaction has already occurred. This can create some tax planning difficulties. For example, in December 2021, the stock market closed at an all-time high. As a result, many public companies paid dividends at record rates and recorded higher-than-average realized gains. The good news was investors received a high dividend and distribution payout; the bad news was investors owed more taxes due to the unexpected increased income. Overall, it is a good problem to have. However, it is nice to be alerted for possible tax liability ahead.
For these reasons, Exchange Traded Funds (ETFs) may be a more tax-efficient investment vehicle for consideration in your non-retirement accounts. ETFs often look, and may even be structured, to mirror the investment strategy of a mutual fund. However, their tax treatment on capital gains is different. ETF fund managers can make changes to the interior fund holdings without triggering flow through realized capital gains to the shareholder at year-end. Additionally, ETF managers can pick and choose the specific shares they swap out within the fund, allowing them to strategically sell their holdings with the lowest cost basis and reducing the end tax liability to the investor when the ETF is sold. Unlike mutual funds where taxable gain or loss on the investment can be realized with no transaction initiated by the investor, with ETFs, gains or losses are only triggered at the time of sale by the investor. Annual interest and dividend payments from ETFs remain taxable.
One way to reduce anticipated taxable gains is to harvest losses. Harvesting losses means strategically selling some of your equity positions that are down in value from their original purchase price, to obtain the tax loss benefit. By not holding or repurchasing the losing stock for 30 days, you can realize a taxable loss on your tax return that can offset capital gain, dollar for dollar. Alternatively, if you do not have capital gain to utilize against your realized loss, the capital loss can offset ordinary income up to $3,000 per year. Unused loss can be rolled forward indefinitely to offset future realized capital gain, or to offset ordinary income at the annual income limits set by the IRS.
Keep in mind that taxable gains and losses are only applicable to after-tax investments. For retirement accounts like your IRA, your distributions or withdrawals are taxed as ordinary income annually. The IRS does not care if the money taken out of your retirement account is at an investment gain or a loss, as all distributions are taxed as income. For after-tax accounts like your Roth IRA, your withdrawals are potentially tax-free. That means the more the merrier, and bring on the dividends!
Financial strategies are most successful when you examine your whole investment portfolio together. Each asset has advantages and disadvantages, but even these often can complement each other when you craft an investment strategy in union. Consider getting a second opinion from your Certified Financial Planner™ before the year is over. Happy Holidays and best wishes to all!