Personal finance

Why these investors might face a surprise tax bill around the corner

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There’s a downside to this year’s stock market appreciation: Some investors are in line for a surprise tax bill.

Mutual funds distribute capital gains to their investors close to the end of each year. By now, many investors have received notifications from their fund companies about that, and they can expect to receive the gains in December.

While this isn’t a problem for mutual funds held in tax-deferred accounts, like 401(k) plans and individual retirement accounts, those with taxable accounts will take a hit from these distributions.

“It’s been a decent year for the market and I would imagine that we’ll have some significant capital gains payouts,” said Russ Kinnel, director of manager research at Morningstar.

These distributions are considered long-term capital gains, according to the IRS. For most taxpayers, these are taxed at a rate of 15%.

You can also expect to get a Form 1099-DIV early next year with the details of the distribution. Hang on to this form, as you’ll need it when you file next April.

So far, 2019 is looking strong for stocks, notwithstanding occasional volatility. The S&P 500 index is up by more than 20% year-to-date.

Surprise gains distributions pose a planning conundrum for financial advisors.

“When you get forced distributions and you don’t know what they are until the end of the year, it’s harder for tax planning,” said Alex Brusda, portfolio manager at North Star Asset Management in Neenah, Wisconsin.

Also, unwinding large holdings of mutual funds that spit out taxable distributions can take years, he said. Selling out of a large position too quickly could also result in a tax bite, so it must be done gradually.

“We’re being cognizant of the gains and the client’s overall tax bracket,” Brusda said.

As clients sell holdings, they can replace these funds with more tax-efficient, low-turnover funds within their taxable accounts.

Likely culprits

Some mutual funds are more likely than others to have large capital gains distributions.

“For an actively managed fund, it might be more of a concern than a passively managed or index fund,” said Oscar Vives Ortiz, CPA and member of the American Institute of CPAs’ personal financial specialist committee. That’s because active fund managers are buying and selling more frequently than index funds in order to boost returns.

Another issue: large outflows during the year. That’s because fund managers must sell holdings to cash out departing investors.

“If you have inflows, it reduces your capital gains,” said Kinnel. “If you increase your investor base by 20% this year, you’ve spread the gains across more people.”

See below for a list of 10 funds with hefty expected capital gains distributions for this year, according to Morningstar.

“If you’ve shrunk your base by 20%, you have fewer people to take the distribution and you must sell more to meet the redemptions,” Kinnel said.

Finally, manager changes — especially bringing on a new subadvisor — could also set off capital gains.

“A more typical manager change, perhaps if someone on the team is promoted, they presumably won’t make big changes to the strategy,” Kinnel said. “But a subadvisor that’s new might change the portfolio.”

Mitigating the impact

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Investors hoping to mitigate the effect of these distributions should bear in mind where they hold these funds.

“It’s asset location,” said Kinnel. “More broadly, funds that are less tax-efficient — like a fund with a high turnover strategy — might work better in a tax-deferred account.”

Meanwhile, funds that are less likely to generate distributions might be better contenders for your taxable accounts.

“If you want to invest now in a taxable account, I think exchange traded funds and passive funds are good options,” Kinnel said.

Timing also matters if you’re buying funds for your taxable account. Wait until after the distributions have been made before you invest.

More from Personal Finance:
Here are the hidden benefits of a Roth IRA conversion
Everything you need to know about your 2020 taxes
How to spend your retirement savings without triggering a tax penalty

“Hold off until after the distributions clear so that you aren’t paying taxes on an investment you’ve only held for a week,” said Ortiz.

Finally, consider tax-loss harvesting, where you deliberately realize a loss in your brokerage account to offset capital gains, said Greg Ghodsi, managing director at the 360 Wealth Management Group of Raymond James in Tampa.

There may be other assets outside of your brokerage account that might provide good opportunities for capital losses, too.

“You’ll want to coordinate with your CPA and your financial advisor,” Ghodsi said.

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