Many stock mutual funds can quietly rob unsuspecting investors by creating unnecessary taxes. This primarily occurs when mutual funds are held outside a tax-favored work retirement plan, individual retirement account or Roth IRA. To help understand why this occurs, it is important to first learn about how stocks that are not owned within a mutual fund are taxed. For simplicity, this article will focus only on federal taxes and will not delve into potential state tax implications.
How Are Your Stock Investments Taxed?
Investors typically purchase individual stocks vs. mutual funds in anticipation of dividends and future gains. Gains from stocks that have been held in excess of 12 months are called long-term capital gains. Both qualified dividends and long-term capital gains are taxed favorably when compared to ordinary income taxes. Gains from stock that have been held for less than 12 months are called short-term capital gains and are taxed at your ordinary income rate.
In addition to favorable taxation relative to ordinary income, other benefits of individual stock ownership include:
You control when you want to sell appreciated stocks, thus determining when capital gains tax will be paid.
You may be able to decrease your taxable income by selling stocks that have decreased in value. This can save you money in a few different ways. You can use the loss in value of one stock to offset the gain in value on a different stock, thereby minimizing or eliminating taxes related to the gains on a stock sale.
If you have a loss on one stock without an offsetting capital gain from a different stock, you can use your loss to reduce your taxable income by up to $3,000 per year. Additionally, unused losses from one year can be carried forward indefinitely to offset future capital gains or reduce taxable income by $3,000 per year until the entire loss is used up.
You have the ability to donate appreciated shares of stock directly to charities. This can help you in two ways. First, you can eliminate the capital gains tax owed by donating appreciated shares of stock. Second, you can also deduct the charitable gift if you are able to itemize deductions.
If you die holding appreciated stocks, your spouse, children or other beneficiaries can receive a step-up in cost basis. This will essentially wipe out any taxes attributed to previous gains upon the beneficiary’s sale of the stock. Only gains that occur after the stock is inherited will be subject to capital gains taxation upon liquidation.
Minimizing Your Mutual Fund Tax Burden
Despite the many possible tax benefits associated with an intelligently managed portfolio of stocks, there are also potential drawbacks. Intelligently splitting stocks into enough categories, sectors and subsectors for proper diversification is something many investors and advisors are not comfortable doing.
To remedy this situation, many investors and advisors prefer to achieve diversification through the use of mutual funds. However, while mutual funds can help provide diversification, they can also come with a hefty tax price.
When you buy a mutual fund, you are purchasing a basket of stocks that may have already appreciated in value prior to your purchase, so in essence you could be inheriting the gains enjoyed by the previous investors of the mutual fund. This is sometimes referred to as Potential Capital Gains Exposure. If these appreciated stocks were sold by the mutual fund manager after you purchased the fund, you would share in the tax implications attributed to these gains, even if the mutual fund did not increase in value for you.
One strategy that can be helpful when analyzing a mutual fund’s tax efficiency includes comparing a mutual fund’s tax-adjusted return rank relative to others in the same category.
Explore Your Options
There are many ways to minimize the tax burden on investment portfolios that are not held within a tax-favored work retirement plan, IRA or Roth IRA. The following illustrates a few potential options to explore:
Own a diversified portfolio of stocks that is managed in a tax-sensitive manner relative to your unique circumstances.
Explore mutual funds with favorable potential capital gains exposure and tax-adjusted returns.
If there are certain funds that you would like to own that have poor tax-efficiency attributes, consider owning these funds inside tax-favored work retirement plans, IRAs, or Roth IRAs, where you do not have to worry about the annual tax burdens associated with dividends and capital gains distributions.
This is an updated version of Ty Bernicke’s article originally published in Forbes on October 4, 2019.
The use of Ty Bernicke’s research or publication of articles he has written does not indicate an endorsement of his work as an Investment Advisor. The publications did not receive compensation for publishing Mr. Bernicke’s work.
The views expressed represent the opinion of Bernicke Wealth Management. The views are subject to change and are not intended as a forecast or guarantee of future results. This material is for informational purposes only. It does not constitute investment advice and is not intended as an endorsement of any specific investment. Stated information is derived from proprietary and nonproprietary sources that have not been independently verified for accuracy or completeness. While Bernicke Wealth Management believes the information to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability. Statements of future expectations, estimates, projections, and other forward-looking statements are based on available information and Bernicke Wealth Management’s view as of the time of these statements. Accordingly, such statements are inherently speculative as they are based on assumptions that may involve known and unknown risks and uncertainties. Actual results, performance or events may differ materially from those expressed or implied in such statements. Investing in equity securities involves risks, including the potential loss of principal. While equities may offer the potential for greater long-term growth than most debt securities, they generally have higher volatility. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles, or from economic or political instability in other nations.
