Planner's pulpit
Making Lemonade Out of Lemons
Posted on November 12, 2008 by Rev. John F. Harrison, CFP®
It's capital gains season in the land of mutual funds. That's usually a good thing. This year, it's something of a bummer. To understand why, we need to review some mutual fund basics.
Mutual funds can generate profits for their owners three ways. First, there are dividend distributions. When the fund owns stock in a company that declares a dividend - that is, a distribution of profits to stockholders - then the funds pass those dividends through on a pro rata basis to its shareholders. This is generally good news. The receipt of dividends from a company confirms that said company has profits to distribute. And qualified dividends are taxed at lower rates than ordinary income, so it's a tax-efficient way to make money.
Another source of mutual fund profits is capital gains distributions. This happens when the fund managers liquidate some of the fund's securities holdings at a profit. It means the fund succeeded in buying low and selling high, the aim of all equity investors. And like qualified dividends, long-term capital gains are taxed under current law at a lower rate than ordinary income.
Finally, investors can profit from a mutual fund when they sell their own shares of the fund itself for more than they paid for them. This is a capital gain on the mutual fund itself, as opposed to the capital gains distribution received from the fund on stocks sold by the fund.
What complicates things in 2008 is that most stock mutual funds have lost value for the year - some quite substantially. Some funds had to liquidate profitable positions to meet demands for redemptions by investors who bailed out of the markets. This can create unplanned and unwanted capital gains distributions. If you started the year with $50,000 in a particular fund, maybe that fund is now only worth $38,000. That's painful enough. But to get a 1099 in the mail informing you of taxable capital gains distribution for the year adds insult to injury. People don't like it when an investment simultaneously shrinks in value and adds to their tax bill!
What should you do? First, keep in mind that this will only be an issue in a taxable account - funds held in an IRA, 401(k), or similar tax-advantaged account do not have this problem. In your taxable accounts, if your reasons for buying the fund were valid, and your goals and risk tolerances haven't changed, you may want to just grin and bear it.
But some investors should consider tax loss harvesting. This involves selling off the losing funds, to realize a capital loss - which can be used to offset taxable gains. If your capital losses exceed gains, you can use the losses to offset ordinary income, up to $3,000 per year. Losses above this level can be carried forward to future year. Just don't run and out and replace the funds you liquidated with substantially identical ones. Buying substantially identical securities within 30 days before or after the liquidation creates a "wash sale," and makes you unable to claim the capital loss.
Talk with us about whether or not tax loss harvesting might make sense for you.
Making Lemonade Out of Lemons
Posted on November 12, 2008 by Rev. John F. Harrison, CFP®
It's capital gains season in the land of mutual funds. That's usually a good thing. This year, it's something of a bummer. To understand why, we need to review some mutual fund basics.
Mutual funds can generate profits for their owners three ways. First, there are dividend distributions. When the fund owns stock in a company that declares a dividend - that is, a distribution of profits to stockholders - then the funds pass those dividends through on a pro rata basis to its shareholders. This is generally good news. The receipt of dividends from a company confirms that said company has profits to distribute. And qualified dividends are taxed at lower rates than ordinary income, so it's a tax-efficient way to make money.
Another source of mutual fund profits is capital gains distributions. This happens when the fund managers liquidate some of the fund's securities holdings at a profit. It means the fund succeeded in buying low and selling high, the aim of all equity investors. And like qualified dividends, long-term capital gains are taxed under current law at a lower rate than ordinary income.
Finally, investors can profit from a mutual fund when they sell their own shares of the fund itself for more than they paid for them. This is a capital gain on the mutual fund itself, as opposed to the capital gains distribution received from the fund on stocks sold by the fund.
What complicates things in 2008 is that most stock mutual funds have lost value for the year - some quite substantially. Some funds had to liquidate profitable positions to meet demands for redemptions by investors who bailed out of the markets. This can create unplanned and unwanted capital gains distributions. If you started the year with $50,000 in a particular fund, maybe that fund is now only worth $38,000. That's painful enough. But to get a 1099 in the mail informing you of taxable capital gains distribution for the year adds insult to injury. People don't like it when an investment simultaneously shrinks in value and adds to their tax bill!
What should you do? First, keep in mind that this will only be an issue in a taxable account - funds held in an IRA, 401(k), or similar tax-advantaged account do not have this problem. In your taxable accounts, if your reasons for buying the fund were valid, and your goals and risk tolerances haven't changed, you may want to just grin and bear it.
But some investors should consider tax loss harvesting. This involves selling off the losing funds, to realize a capital loss - which can be used to offset taxable gains. If your capital losses exceed gains, you can use the losses to offset ordinary income, up to $3,000 per year. Losses above this level can be carried forward to future year. Just don't run and out and replace the funds you liquidated with substantially identical ones. Buying substantially identical securities within 30 days before or after the liquidation creates a "wash sale," and makes you unable to claim the capital loss.
Talk with us about whether or not tax loss harvesting might make sense for you.
Recent posts:
Making Lemonade
Health Savings Accounts
REMNDR
News Flash
How bad is it?
It's no secret
Responding to market mayhem
Is there a topic you'd like us to talk about? Email your suggestions or questions to us.
Making Lemonade
Health Savings Accounts
REMNDR
News Flash
How bad is it?
It's no secret
Responding to market mayhem
Is there a topic you'd like us to talk about? Email your suggestions or questions to us.
