I have a basic philosophy in life- control the stuff that you can. Understand it, learn about it to empower yourself with the best possible information to make quality decisions.
Unfortunately, we don’t have power in many areas in our lives. With the rest, roll with the punches for the stuff that you cannot control. Keep it going and adjust as necessary.
Listen, we can’t control what happens in an individual stock or security. Well, maybe Warren Buffet can. I suppose if I had a couple of billion dollars, I could drive up the price of a stock.
Yet, we’ve all seen people go broke or make really crappy financial decisions.
Here’s the thing- you CAN control the capital gains and dividends when you OWN individual stocks and ETFs.
That’s because you can sell them AT ANY TIME during the business day. You can sell a position AT A LOSS or AT A GAIN. Nobody is going to force you to sell a position.
Unfortunately, it is much more difficult to control with mutual funds. Let me explain.
Mutual funds can have “phantom capital gains”. Essentially, mutual funds will distribute capital gains even when YOU haven’t sold anything. Instead, the active manager is buying and selling securities on your behalf. As assets come into the fund, they will buy stocks or other securities. Then, when investors redeem their money, the manager will have to sell stocks or other securities.
This means that are subject to the whim of investors. This can be bad news for tax efficiency! If you are in a “hot fund” that had capital gains from UNSOLD positions that the manager bought years earlier (BEFORE you even invested in the fund) and investors start pulling the dough, you could be left with a BIG tax bill when you don’t want it.
As a matter of fact, you could actually LOSE money in a mutual fund and still get caught with a capital gain distribution. Let me an example for a case where this happened.
Consider this case for example:
Performance from 2006 to 2013
If you invested on January 1st 2006, you would have been a very happy camper in 2006 and 2007. You would have been up 80% plus in two years! That’s awesome.
But, let’s say that you held onto the fund through 2008, you would have LOST -61.27% and on top of that because of all the share redemptions, you would have owed taxes- BOTH short-term capital gains (taxed at ordinary income- YUCK) and long-term capital gains (taxed at favorable rates) for a total of 41.86% of your investment!!!
You might be down 30% overall since your initial investment and would have to pay gains on an investment YOU haven’t made overall gains on since your initial investment. It’s nuts!
However, it could be worse, you could be the poor shmuck who saw the track record in 2006 and 2007 and thought that this investment was a “sure bet” in 2008.
If the poor person, invested $100,000 in a specific stock on 1/1/2008 and didn’t sell it by the end of the year, their investment would have been worth about $39,000 and on TOP of that, they would have owed capital gains taxes on about $16,000 of that investment.
And to add insult to injury, they have NEVER even seen a year of gains in the fund, unlike the relatively luckier person who invested on 1/1/2006 who experienced two great years.
Anyhow, needless to say, you need to be VERY careful which mutual funds you invest in. Some managers are incredibly tax efficient, but you need to be aware if they are when you are investing in non-qualified money.
Now, I’ll step off that soapbox and we’ll focus on more practical ways to help you with “Tax Harvesting”.
The basic idea of tax harvesting is that you purposely create CAPITAL GAINS or CAPITAL LOSSES.
If you had a capital loss, how much did you write-off on your taxes? Did you have a carry-forward capital loss?
If you had capital gains, here’s the rub: the government has NO ceiling on the amount it can tax you. You will get taxed on $3,000 of gain, $25,000 of gain, or even $100,000 of gain if you experience (realized) that gain.
Unfortunately, the reverse is NOT true. The government does have a FLOOR on the losses you can write-off for capital losses. As a matter of fact, you can ONLY write-off $3,000 of losses per year in excess of your gains. This is why people have carry-forward losses that rolls over into the following year (or years!). It really ticks me off frankly, but that’s the way it is.
What you have to do is MANAGE your capital gains by harvesting what you need.
For example, let’s say it is November 30th, you will want to explore your REALIZED and UNREALIZED gains/losses year-to-date.
Perhaps, you have NO carry forward losses and for the year you have realized some capital gains. Review over all of your non-qualified accounts and see if you have a position or two that may have been in the doldrums since you invested.
You may have some CAPITAL LOSSES that you can HARVEST to off-set the gains and even create a loss for the year while continuing to hold onto your winners.
That is tax efficiency, my friends, with you controlling what you can!
By the way, you will want to wait at least 31 days before re-buying that security. The IRS calls this a “wash sale” if you buy it sooner and it cannot be written off.
Let’s flip that scenario around, what if instead you DO have carry forward capital losses? You will instead want to HARVEST your CAPITAL GAINS.
I’ve seen people with $100,000 or even $200,000 worth of carry-forward losses. At a mere $3,000 year write-off, it would take 33 years to write off $100,000!!
Remember to be careful. It may make sense to keep $10,000 to $15,000 of losses that you could write-off in the foreseeable future.
Unlike losses, there are no regulations surrounding selling positions at a gain. The IRS doesn’t care if you sell it and then buy it back the next year.
Have you had any mutual funds with phantom capital gains in 2008 or 2011 or 2015? Do you have any questions about how to best manage your capital gains and dividends? I'm happy to sit down with you and come up with a great plan. Feel free to contact me [email protected]
Advisory services through Capital Advisory Group Advisory Services LLC and securities through United Planners Financial Services of America, a Limited Partnership. Member FINRA and SIPC. The Capital Advisory Group Advisory Services, LLC (CAG) and United Planners Financial Services are not affiliated.
The views expressed are those of the author and may not reflect the views of United Planners Financial Services. Material discussed is meant to provide general information and it is not to be construed as specific investment, tax, or legal advice. Individual needs vary & require consideration of your unique objectives & financial situation