Capital Gains Taxes On A Loss? How?

40327930_sAs most of you know, we teach a retirement course at Cape Cod Community College. In the class, we teach folks how to build a retirement system. Part of the class is designed to help folks understand the impact of capital gains taxes on that system.
At our last class, I was explaining the differences between short-term and long-term capital gains when a women in the back of the room raised her hand to ask a question.
Jane had just finished her taxes and wanted to know why she would have to pay capital gains taxes on her investments even though she lost money in her portfolio.
Ah, the “Phantom” has returned.
Unfortunately, after the tumultuous year in the markets in 2015, this is a commonly shared sentiment among investors who have taxable accounts and prescribe to a particular investment strategy. So, why do some people need to pay capital gains taxes if they lost money?
You see, a common misperception that many people have is that all investments and investment strategies are created equal for tax purposes. But that is not the case. Let me explain.
Generally, a mutual fund distributes its earnings, if any, minus the expense of running the fund, to its shareholders. When an investor holds shares of a mutual fund in a taxable account, the investor must pay taxes on the fund’s earnings, whether those earnings are distributed in the form of cash or are reinvested. For example, when a mutual fund manager sells appreciated securities within the fund, this results in a capital gain. Each shareholder must pay capital gains tax on his or her share of that capital gain, whether there is a net distribution in the form of cash or a reinvestment in the fund. So, even if by the end of the year, a shareholder’s account has gone down because the mutual fund has lost value, each shareholder will need to pay capital gains tax on any capital gains realized throughout the year within the fund, if the fund is held within a taxable (non-qualified) account. Each such shareholder must also pay income tax on any dividends paid within the fund. This is what we call phantom income tax.
Let’s break this down into numbers so we can understand what Jane might be looking at.
Let’s say that Jane had $250,000 in a taxable brokerage account and in 2015 she invested it in “A” shares of some popular mutual funds. As you know from our prior discussions, “A” shares charge brokerage commissions up front in exchange for a lower yearly expense ratio. So, right off the top, let’s deduct 5 percent, or $12,500, from the value of Jane’s account, leaving her with a balance of $237,500.
Now, let’s assume that Jane’s mutual funds had a tough year and the value of her account dropped by 20 percent. She lost another $47,500. This can happen in the market, right, especially with a year like 2015? So for those of you checking the math along with me, that takes Jane’s account down to the $190,000 mark.
So now, it is April 2016 and Jane is sitting down to do her taxes. She opens the year-end statement from her brokerage house. There is a Form 1099 listing each mutual fund and outlining each fund’s dividends and capital gains that Jane must pay income taxes on. Really? She is down $60,000; she has market losses of $47,500, and she needs to pay capital gains taxes to Uncle Sam? Yes, the Phantom has arrived.
Investors buy mutual funds because of their perceived flexibility, ease of diversification, and returns that can make them seem attractive. But, as I always warn, you need to dig into the details, including the tax ramifications, of any financial vehicle before making a decision to use it in your financial plan.
So, what do you do? How do you minimize tax inefficiencies to help mitigate the Phantom? Generally speaking, if you still choose to own “actively managed” mutual funds wrapped in that outdated buy-and-hold strategy, then they are best held in your tax-deferred accounts such as your IRAs or 401(k)s, rather than your taxable brokerage accounts.
As I’ve said before, taxes are one of the few guarantees in life but certain tax strategies can minimize the amount you may need to pay. Your retirement plan should include an advanced tax plan before you determine the placement of a single dollar in your portfolio.
Folks, markets go up and markets go down. Don’t let the Phantom sneak up on your 2016 taxes. Seek out a retirement specialist and review your portfolio now to see what moves you need to make to keep the Phantom on the run.
Be vigilant and stay alert, because you deserve more. Have a great week.