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Wealth Management - September 2017

by Stacy Wise | Sep 25, 2017

Year-End Surprise from Mutual Funds

By Rick Imhoff, CFP ®

Mutual funds have been around a long time and many investors, with both large and small portfolios, have invested in them as part of their short and long-term investment objectives.  They are a good investment vehicle for diversification, but investors should be aware of some of their unique characteristics.

Portfolio managers for mutual funds will buy and sell securities throughout the year.  In passively managed funds that follow an index, the amount of trading activity is typically low.  Trades only occur when there are changes to the index or cash is needed to meet redemption requests that exceed the available cash held by the fund.

In actively managed funds, the amount of trading activity by the portfolio managers can be high, but can also be low depending on the manger’s investment approach.  In general, the more frequent the trading, the more realized capital gains and losses the fund may incur within its fiscal year.  If the portfolio managers are mostly successful in their trading activity, the fund may end of up with a net realized capital gain.  If this occurs, the fund is required to distribute nearly all that gain to the shareholders.  This distribution typically occurs late in the fund’s fiscal year.

Shareholders can choose to take the distribution in cash or reinvest it to buy more shares.  Regardless of how the distribution is handled, if the fund is held in a taxable account, the distribution will be included in the shareholder’s gross income in the tax year the distribution was made.  Some of the distribution may be considered short term gains and taxed at the ordinary income tax rate.  Some of the distribution may be considered long term gains and taxed at the more favorable long-term capital gains tax rate.

The problem with these capital gains distributions is that the shareholder is unable to control the timing of taking gains and may result in additional income taxes for the shareholder.  To add to the problem, these distributions are usually paid late in the calendar year not leaving the shareholder with a lot of time to do some tax planning.

As we come to the end of another calendar year and you own mutual funds in a taxable account, you can take some actions to help deal with this year-end surprise.  Most mutual funds will publish a report about 30-60 days prior to the payment of any capital gains distribution with an estimate of what those distributions might be.  This can give you a little more time to consider any tax planning options, such as taking losses on other underperforming assets, making more charitable contributions, or adding more to your retirement plan.

Of course, you don’t want tax issues to override sound investment decisions.  Receiving a capital gains distribution is a good thing from the perspective that the portfolio managers for the fund did a good job of making money on their trading activity.  Also, if the fund continues to meet your investment objective and fits within your long-term asset allocation strategy, you need to plan for these distributions each year.

However, if the fund no longer meets your overall objectives, you might consider investing in a fund that is more tax sensitive or passive in its investment approach. Again, your primary focus should be on the economic benefit of an investment decision, not solely on the tax consequences.

Prior to taking any tax related action, you should consult with your tax advisor to consider all options regarding the reduction of income taxes as it relates to your unique situation.

Rick Imhoff, CFP®, is Senior Vice President & Senior Trust Officer for MidAmerica National Bank. He can be reached at 309-647-5000, ext. 1130 or by email.

Investments are not FDIC-insured, hold no bank guarantee, may lose value, are not a deposit, and are not insured by any federal government agency.

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