Tax Day is Quickly Approaching

Tax Day is Quickly Approaching

by Tyler Vernon

April 15th is right around the corner and some investors are being surprised with tax bills.  Specifically, investors in equity mutual funds are seeing that not only were their portfolios down last year, but they have the added “pleasure” of paying capital gains taxes for gains that were realized inside their mutual funds.

These investors are learning a valuable lesson that most mutual funds are not tax friendly.  In a year of volatility, a mutual fund may be hit with redemptions as nervous investors sell the fund.  The fund manager must sell stock to meet those redemptions, which may trigger capital gains, especially if the volatility comes after a great year in the market like what we saw in 2017.  In this scenario, an equity mutual fund investor who bought into a fund in mid-2018 would have most likely seen their account value drop.  Additionally, as the portfolio managers sold underlying securities to meet these redemptions, it triggered capital gains taxes to the shareholders.  At Biltmore Capital, we prefer clients have the ability to tax manage their portfolio, so we don’t have these kinds of tax surprises.  Using low cost exchange traded funds (ETF’s) in lou of mutual funds may be a solution to the tax management problem as these funds typically don’t force out capital gains to investors and they allow you to tax harvest very easily.

While we can’t do anything about last year, we can remember these issues and take action for future years.  For investors, we must realize that a loss has value.  They can “harvest” their losses by selling securities trading below cost and using losses to offset gains, as follows:

  • Short term losses (investment held less than one year) can be netted out against short term gains
  • Long term losses can offset long-tern gains
  • Short and long term results can be combined. So a loss in one section can offset a gain in another.  This means that long/term losses can be just as valuable as short term losses.

If there are still losses left over, they may be used to offset $3,000 of ordinary income.  If there are still losses, they can be carried forward to offset gains in future years.

When selling a security at a gain, it is very important to know when the security was purchased.  The government encourages investors to keep investments longer term (a stock becomes a long term holding when it is held for 366 days).  As a result, there is a lower tax rate for long term capital gains as opposed to short-term capital gains.  Short term capital gains are taxed at the same rate as ordinary income.  For someone in the highest tax bracket, this could be over 40%.  On the other hand, for this same individual in the highest bracket, long term gains are only taxed at 23.8%.  Rapid trading within a mutual fund can strip out this long term tax treatment so it’s important to understand the turnover within a typical portfolio.  Additionally, one should look at the build in capital gains before investing in a mutual fund.  These built in capital gains represent the appreciation of positions that the fund has on their balance sheet that you will acquire when buying into the mutual fund.  If the mutual fund manager decided to sell these appreciated positions a day after you buy in, you will be taxed on these gains since you are a shareholder, even though you didn’t participate on those gains over time.  Investors beware!

My personal experience has been that both investors, and advisors alike fail to go a great job at tax managing portfolios.  Fees and taxes can often be an investors worst enemy and tax management is something that we can control

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