If you have mutual fund investments in non-IRA accounts – you’re about to be taxed even though you’re losing money this year. Fortunately, there is time to do something about it if you take action now. This article is intended to explain what is happening and how we can avoid it if we act quickly.
So, what are we even talking about?
Commonly, investors use mutual funds as a way to diversify their holdings. As a pooled investment, mutual funds allow investors to combine their investment dollars in order to spread those funds amongst hundreds or thousands of stocks. Unfortunately, obtaining those economies of scale and diversification benefits comes at the price of tax inefficiency.
What are your "personal" realized and unrealized gains?
Let’s start small to explain realized and unrealized gains. Let’s say that you bought a single stock for $1, and the value of the stock increased to $3. If you decide to keep the stock, you have an unrealized gain of $2. However, if you decide to sell that stock, it becomes a realized gain of $2. You calculate the gain by subtracting the original amount of your investment from the sale value. If the result is negative, then you have a loss rather than a gain. In a non-IRA account, you are taxed on gains in the year that they are realized.
Remember, mutual funds are collections of stocks that are bundled together into shares. When you buy a share of a mutual fund, you are buying into a pool of stocks that may have been purchased long before you hopped in. What’s more, is that you are investing alongside other people who may have been there longer or intend to leave earlier. More on this in a moment…
Why would I be taxed if my fund value went down?
Let’s use a simple example of owning a Mutual Fund ABC. Say you invest $10,000 in Fund ABC on January 1, and through the course of that first year of your investment the fund returns 10% so that your balance at the end of the year would be up to $11,000. You “personally” have an unrealized gain of $1,000. But you will not have to pay tax on that gain until it is formally realized when you sell all of your ABC fund shares.
However, in this example Mutual Fund ABC has been open for many years and let’s further assume that there is only one company stock in the fund and that the fund actually invested $1mil into that company years ago. When we fast forward to the present we see the company’s stock has doubled in price from when they began - so the fund’s investment is actually up 100%. These are called “embedded” gains.
Let’s pause to recap. Your specific investment has yielded you a 10% gain while the fund itself is up 100% over these last years.
Now here comes the important part: Let’s say half of the other investors no longer want to own this fund so they sell at some point during the year. In order to provide those investors with their capital, the fund manager needs to start selling the underlying stock to create the liquidity for their investors. In doing so, they are going to be “realizing” the embedded gains that have built up over the course of these last many years at the fund level.
Meanwhile, you’re still holding your shares and do not want to sell. Unfortunately for you, a significant portion of those historical gains that had been building up over time, now realized, must be passed on to all the shareholders of record at the end of the year. Those gains are taxable in the year received – REGARDLESS OF WHETHER YOU HAD PARTICIPATED IN THE ENTIRETY OF THE HISTORICAL PERFORMANCE OR NOT.
So in this example, even though you did not sell your shares, the actions of half of your fellow investors will have all but assured that half of the historical gains will now be shared by all owners of record.
This means you’re going to pay tax on gains you did not realize or receive. For this reason, investing in mutual funds can lead to unintended consequences when it comes to taxation.
This year, many investors will actually see their investments lose money while being taxed on the realized embedded gains within the fund itself.
What can I do now?
While this year has experienced market declines across the board, we cannot ignore that there have been many prior years of consistent returns in the stock market. Many stock funds have benefitted from tremendous returns over the years, but this year we’ve seen over $500bil (that’s BILLION) in stock liquidations. The long-term gains in these mutual funds are going to be passed to all shareholders of record in the beginning of December, even if you have personally lost money in your account.
We do not want to have our outstanding clients caught off guard by these circumstances, so consider this your call to action if you want to avoid an unpleasant tax experience next spring and you have non-IRA investments in mutual funds. We can help you – but the window to act is very short and closing fast.
Over time, tax-efficient investing can add the equivalent of 1.5%-2.0% annual return to your portfolio on- top of its regular returns. Give us a call today to discuss your specific situation and how we can help create a more tax efficient investing strategy for your family.