When mutual funds buy and sell securities in their portfolios, any gains realized must be passed along to their shareholders. If positions are sold at a loss, the losses can be used by the fund to offset future gains. With the stock bull market now in its fifth year, most funds have worked off any losses accumulated during the 2008 market downturn, resulting in larger than normal gains distributions to shareholders in 2013.
If unexpected, many investors will be writing checks to Uncle Sam in April to cover the tax on these gains distributions. Fortunately, most of the gains should be of the long-term variety and subject to the more favorable 15 percent maximum tax rate for most taxpayers.
New for 2013, however, is the 3.8 percent surtax on net investment income under the Affordable Care Act. This tax applies to the lesser of net investment income or the amount by which modified adjusted gross income exceeds $250,000 for married taxpayers ($200,000 for single tax filers). For example, a married couple with wages of $230,000 and long-term capital gain income of $45,000 would see their gains taxed at the usual 15 percent rate, plus an additional $950 tax on their net investment income (3.8 percent of the $25,000 excess of their adjusted gross income over the threshold amount).
While 2013 gains are already on the books, there are several strategies to keep in mind to help reduce taxes on investment income in 2014 and beyond. First, look for tax-efficient investments for your taxable accounts. Morningstar (www.morningstar.com) can be a valuable resource in determining how tax-friendly your current holdings are. Morningstar provides estimates of potential capital gains exposure and tax cost for funds to help investors gauge how taxes will impact their returns. If one of your current holdings is not tax-efficient, consider replacing it with an index fund or exchange-traded fund. These alternatives inherently engage in less trading, allowing them to keep their capital gain distributions to a minimum.
Second, look for opportunities to defer taxes on investment income. Qualified retirement accounts, traditional and Roth IRAs, and low-cost variable annuities all offer the ability to avoid current taxation of investment income. With the exception of Roth IRAs, the tradeoff with these tax-deferred accounts is that all investment earnings will eventually be taxed as ordinary income rather than the lower rates on qualified dividends and long-term gains. However, if your investment time horizon is long enough, delaying tax can lead to higher after-tax returns. Earnings in Roth IRAs, of course, can be withdrawn tax-free as long as certain age and holding-period rules are met.
Third, take advantage of the different tax characteristics of various account types by putting tax-efficient investments in taxable accounts and less tax-friendly holdings in tax deferred accounts. Managed mutual funds with high turnover, real estate investment trusts and other income-oriented investments are best held in tax-deferred wrappers while filling taxable accounts with index funds, exchange-traded funds and individual stocks.
Next, look to minimize the need to realize gains when rebalancing by having dividends pay to cash instead of reinvesting them in taxable accounts. This way, the dividends can be used for periodic rebalancing rather than having to sell positions at a gain in order to maintain your diversified asset allocation.
Finally, make prudent use of tax-loss harvesting (realizing a loss on a security and replacing it with a similar investment in order to maintain exposure to a specific asset class in your portfolio). Capital losses harvested in this way can be used to offset gains in the current year and up to $3,000 of ordinary income. Remember, however, that the replacement investment will now have a lower cost basis than the position sold, resulting in a larger capital gain to be realized down the road. Therefore, capital loss harvesting should be seen as a tax deferral strategy, rather than a tax savings tool. If your income is high enough when the gain on the replacement investment must be realized, the ultimate tax hit could be larger than if you had just held onto the original position.
David T. Mayes is a Certified Financial Planner professional and IRS Enrolled Agent at Mackensen & Company Inc., www.mackensen.com.