Lose Money and Pay Taxes: Time to Get Rid of Your Mutual Funds?

Most taxes are pretty simple to understand.  The more you earn the more you pay.  But in the investment world, it can be far more complicated than that.  Despite the massive losses in the market this year, many mutual fund investments are expected to pay capital gain distributions. The last time I checked, nobody likes to pay income tax.  But to do so in a year that you’ve seen your investments lose 30% plus, well that’s just plain mean.

Why Do Mutual Funds Pay Out Gains in Down Years?

Typically, mutual fund managers recognize gains in years when the market is down.  The whole idea of “negative return and paying taxes” sounds absurd, but is a reality when it comes to investing.   There are many reasons why this occurs.

Selling Winners

One reason is that mutual fund managers often times sell off “winners” when the market begins to turn south in attempt to lock in gains.   What’s this mean to you the shareholder?  Congratulations, you’ve just received a capital gain for Christmas.

Forced Liquidations

When the stock market gets frantic, people sell.  This year has been a record year of investors cashing out their investments.  It was reported that in just the month of September there was $75 billion worth o f mutual fund redemptions.  That was just September!  When people sell, the managers are forced to sell off positions to cover the requests.  In this case, fear of the markets directly leads to capital gains being paid.

Portfolio Rebalance

Lastly, during severe downturns, fund managers often reposition their holdings to take advantage of different investments that they believe may be poised for improved performance.  Similar occurrences with the tech stocks of the 2000-20002 era will be seen with highly appreciated energy, material, commodities and real estate companies.

Two Tax Efficient Strategies Going Forward

Now that you know why funds will pay out gains in down years, I bet you’re asking yourself what you can do to protect yourself going forward.  Here are two ideas.  Keep in mind, to always consult your tax professional when it comes to minimize your tax situation.

Invest in Tax-Efficient Funds

A fund’s turnover ratio will have a significant effect on the funds capital gains distribution as well as the overall cost of the fund as well.  Be conscious, how high the funds turnover ratio is especially in taxable accounts — the lower the turnover ratio is the better.

This may have you look at Exchange-Traded Funds (ETFs) as an investment choice in your taxable accounts.  Their low cost, low turnover investment style, make them a nice fit for your portfolio.

Tax Loss Harvesting

No, we’re not talking about going down to the Farmer’s Market.  Tax loss harvesting is selling off an investment to take a loss, but then strategically placing the proceeds in another investment to not miss out on future potential gains.  Once again, consult your tax advisor before implanting this strategy.

The end of the year is soon upon us.  It’s not too late to review your portfolio to make sure this won’t happen to you.

Other Tax Planning Articles from Good Financial Cents:

About the Author

By , on Dec 17, 2008
Jeff Rose
Jeff Rose is a Certified Financial Planner and co-founder of Alliance Investment Planning Group. He is also the author of Good Financial Cents, a financial planning and investment blog and he is currently working on his first book entitled Soldier of Finance. You can see more about his mission at the same titled blog Soldier of Finance.com.

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Leave Your Comment (6 Comments)

  1. Jeff Rose says:

    @ Kitty. Your absolutely right on both. With BRK.B, you obviously have less voting rights. I think it’s more of a bragging right to own BRK.A. Here’s a story I found that has more info on the difference between the two shares: http://socialize.morningstar.c.....vId=175721

    On the capital loss rule, yes just $3k per year. Sorry, should have mentioned that. It does carry over until you exhaust it. I’ve had many clients not only take the loss this year but sell off enough to carry the loss over for next year. My optimistic view is to not take the loss, but rather offest any gains….come on bull market!

  2. kitty says:

    One other thing regarding selling to reduce taxes. Keep in mind that while you can apply all of your losses to reduce your capital gains, if you have a net loss, you can only deduct up to $3000 a year from taxes. The rest has to be deferred to the following year.

  3. kitty says:

    Jeff Rose – unless I am mistaken BRK.B is really the same as BRK.A divided by 30. So if their pick is BRK.A, everything they say applies to BRK.B as well. When BRK.A goes up, BRK.B goes up by the same percentage. Same when it goes down.

  4. Jeff Rose says:

    @pinyo and patrick

    You both have me really seriously considering Brk.B. I actually was just reading an investment journal interviewing a deep value manager and their strategy going forward. One of their top picks….good ol’ Berkshire. I assume its the A not B. One day boys, one day will be talking about our A share.

  5. Patrick says:

    My plan is to liquidate the mutual funds in my taxable account as well. I think I will need to take a loss to reduce my taxes. I might just buy some BRK.B also. 😉

  6. Pinyo says:

    @Jeff — Good article. I agree with your assessment about this is being the year where investors will get hit with both paper losses and capital gains distributions.

    In fact, I have taken advantage of the market down turn and liquidated my mutual funds positions in my taxable account. At this point, I am just replacing them with BRK.B for the time being until I can get my arms around what I really want to go in there.

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