Beware Of Mutual Fund Tax Traps

Ty A. Bernicke CFP®, President, Executive Wealth Manager | Posted: April 19, 2021

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 stocks 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. In fact, in 2019, if your taxable income falls below $39,375 single/$78,750 joint, you typically will not owe any tax. If your taxable income is above those figures but falls below $434,550 single/$488,850 joint, your tax will be 15% to 18.8%, and regardless of how high your income tax bracket goes, you will not have to pay over 23.8% on qualified dividends or long-term capital gains.

In addition to favorable taxation relative to ordinary income, other benefits of stock ownership include:

1. You control when you want to sell appreciated stocks, thus determining when capital gains tax will be paid.

2. 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 capital gains tax. 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.

3. 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.

4. 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:

1. Own a diversified portfolio of stocks that is managed in a tax-sensitive manner relative to your unique circumstances.

2. Explore mutual funds with favorable Potential Capital Gains Exposure and tax-adjusted returns.

3. 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 article is designed to help you understand ways to help minimize unnecessary taxes. Please remember that these decisions cannot be made in a vacuum, and the number of different considerations that go into each decision has to be carefully weighed against a variety of factors. Depending on the state in which you live, there may be additional tax considerations.

Originally published: 10/4/2019 (Forbes)

About the author

Ty A. Bernicke CFP®, President, Executive Wealth Manager

Ty Bernicke is the President of Bernicke Wealth Management and serves as a Senior Wealth Manager. Ty currently works with a limited number of clients that require wealth and/or investment management services. His research on investment management, retirement planning, and tax minimization strategies have been published or recognized by The Wall Street Journal, Forbes, The New York Times, Futures Magazine, and many other well-known national and international publications. Ty Bernicke and Bernicke Wealth Management give back to the community and environment through numerous charitable endeavors. Ty spends his free time with his wife, two daughters, and one son. He also likes to fish, golf, and exercise.

Certifications, Licenses, and Registrations

  • Registered Principal with LPL Financial, Member FINRA/SIPC
  • CERTIFIED FINANCIAL PLANNER™ professional
  • Accident, Life, Health, Property, Casualty, and Variable Life/Variable Annuity Insurance Licenses

Education and Training

  • Series 7, 66, 63, 24 held at LPL Financial
  • Bachelors Degree - Finance; University of Wisconsin-Eau Claire
  • College for Financial Planning graduate

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