Taxes are Unpleasant
On February 3, 1913, the 16th amendment to the US Constitution was formally adopted allowing Congress “to lay and collect taxes on incomes, from whatever source derived…” At the time, the initial income tax rate started at 1% and rose as high as 7% on incomes over $500,000. If we were to extrapolate those dollar amounts to 2016, taxpayers would owe 1% on the first $463,000 of income and the 7% bracket would begin at $11.5 million of income. Since then, there have been plenty of changes to the tax code. As an unfortunate result our once simple, less invasive income-tax system gradually turned into the monolithic mess we have today.
Taxes are an unpleasant way of life, but when it comes to our personal finances the tax code does give us some short-term certainty to plan around. As you begin your year-end tax planning, remember that now is the time to address the potential year-end capital gains distributions from mutual funds you own in a non-retirement account. Throughout the year, mutual funds buy and sell securities. The net gains realized as a result of these transactions are distributed to us as shareholders and as a result, we pay taxes on them. What might look like a dividend on your December statement is actually a distribution that reduces your share price by the same amount. You could certainly reinvest the distribution, but your tax liability will still be the same and your terminal wealth will be no different. In the worse case scenario, this is a form of phantom income because you could find yourself paying taxes on a fund that didn’t make any money.
Here are some helpful steps to avoid this scenario:
• Confirm the expected capital gains distributions for each of the funds you own. These amounts are typically listed on the mutual fund company’s website or just call the fund company directly. Most mutual funds have already posted their expected capital-gains distributions for 2016.
• Determine whether you have realized losses in your portfolio this year to offset some or all of these capital-gains distributions.
• If you don’t currently have realized losses in your portfolio, check to see if any of your investments that have declined in value below their original purchase price. Selling these investments for a loss can also help offset capital-gain distributions.
• Keep in mind that the wash-sale rule disallows losses on an investment if you buy back the same investment within 30 days of selling it. Instead, look for a different fund that has comparable characteristics to the one you just sold, but don’t buy the fund, or any other fund for that matter, until after the year-end distributions have been paid otherwise you will pay taxes without experiencing any gain.
• Low cost, low turnover mutual funds and exchange traded funds are the most reliable structures to avoid these distributions. Consider giving your portfolio a complete “tax liability makeover” in the near future.
As 2016 draws to a close, prepay those 2017 property taxes and 4th quarter state income tax payments, make year-end charitable deductions and ask for bonuses to be deferred into 2017 but don’t neglect your portfolio. With a little work and/or a little help, you might find some tax savings.