A $3,000 End of The Year Surprise

May 30, 2019
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Last year towards the end of the year, I started working with a new client whom works at the Walt Disney Company seasonally during his retirement. As I was running through our list of action items, there was one thing that seemed to be overlooked previously that would cause a major issue for this client. As I brought up the point, he was completely unaware of the impact to him. In fact, this is a recurring issue and something that could’ve been addressed quite some time ago, but it had not been pointed out.

What was the issue, you might ask? It was the fact that his mutual fund investment distributed capital gains to him at the end of the year. No big deal you might say, but big deal it was. The capital gains distributions were almost $20,000. I’m no tax adviser, but I believe for a person in the 15% long-term gain tax bracket, that is roughly $3,000 in taxes he was going to have to pay for the pleasure of owning said funds.

What’s more, he did not sell the funds to create the capital gains himself. So, how did he end up with this mess towards the end of the year?

Simple, mutual funds will distribute capital gains to their shareholders, typically towards the end of the year. “But, he did not sell the fund” you say. Doesn’t matter. “The market was down in value last year though” you quip. There were gains none the less.

How so? Think of it this way, a mutual fund, by design, has hundreds, if not thousands or millions of individual and/or institutional investors. Naturally then, these investors will all have different needs throughout the year. Some might put money into the fund, some people will take some money out. All along the way, the mutual fund itself must adjust its holdings for these various flows of money. Therefore, even if you hold a mutual fund and do not sell it, you may end up receiving capital gains towards the end of the year. Don’t believe me? Go check your own return if you hold mutual funds in a taxable account.

What does one do then to avoid or mitigate this from happening? I’m glad you asked. Here’s a short list which is certainly not exhaustive:

1.      If you’re investing in a taxable account, consider other vehicles that may be able to align with your goals, but that might not be a mutual fund.

2.      If there is time before year-end, you might be able to tax-loss harvest to offset those gains.

3.      Gift some assets.

Now, the upside of this happening is it does also step-up your cost basis in the fund, so if you do decide to sell at a later date, the realized gain might not be as large as if the money were invested in some other vehicle. This is why it is important to understand not only the risk you take when investing in mutual funds, but the tax ramifications as well.

Since the tax deadline is fast approaching, now might be a good time to look through your return and see if you fell victim to this often-overlooked aspect of investing in a taxable account.This way you might be able to make adjustments this year before having the same issue repeat itself.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.