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.
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.
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.
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.
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.
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.
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.
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.
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