Fall is in the air, football is back, and the weather in South Louisiana is finally getting cooler. This is also a good time to assess your client’s income taxes from their taxable investments. You’ll have until the close of trading Dec. 31 to take action. However, if you’re going to attempt to reduce your client’s tax liability, you should act well before then, since most funds make their annual capital gains distributions in December and some as early as October.
Tax Liability: The Source
In general, clients with a nonqualified or taxable account may be subject to income taxes. If they invest in a mutual fund or ETF, their tax liability will result from dividends, interest and capital gains distributions, or from selling an investment at a gain during the year. As an advisor, you may be able to reduce the amount your client has to pay and increase your value proposition in the process.
Many funds make distributions throughout the year. For example, funds with fixed income securities typically make a distribution each month (i.e. interest). Funds that invest in stocks normally make a quarterly distribution (i.e. dividends). As mentioned, most funds make their capital gains distribution in December, although a few distribute in October. It’s important to note that stock ETFs rarely make a capital gains distribution due to their structure. This fact alone makes a compelling argument for incorporating ETFs into a portfolio. To learn more about the difference in the tax treatment of mutual funds versus ETFs, read: Under the Hood: Tax Treatment of ETFs vs. Mutual Funds.
Offsetting Capital Gains
If your client expects to have a 2015 capital gains tax liability, you might consider selling one of their existing funds at a loss to offset their gains. There is one caveat, though. In order to claim the loss, they cannot invest in the same fund during the 30-day period immediately prior to, or after, the liquidation date. If they ignore this, they may be ineligible to claim the loss due to the wash sale rule. However, it is permissible to invest the proceeds in a different fund, even if the replacement fund is in the same subcategory. For example, if you sell a Large Value stock fund at a loss and immediately buy a different Large Value stock fund, the wash sale rule will not apply.
One final note. It’s not a good idea to invest in a fund just prior to its capital gains distribution date. Why? Because doing so will subject the account holder to the capital gains tax, even though they weren’t invested in the fund throughout the year and didn’t enjoy the fruits of the gain. In essence, investing in a fund just before a capital gains distribution is essentially buying a tax liability. Therefore, if you need to invest in a stock fund late in the year, it’s best to use a stock ETF or a mutual fund that won’t have a capital gains distribution. Finally, if you own a stock mutual fund that is expecting a large capital gains distribution, it may be wise to sell it before the record date and buy a different mutual fund after its record date, or an ETF at any time.
Until next time, thanks for reading and have a great week!