The IRS considers capital gain distributions as long-term and gives them more favorable tax treatment, but that doesn't totally ease the pain when the taxable amount is unexpectedly large. Such is the case for many market players during a bull market. One investor, for example, found one year that his mutual fund portfolio produced distributions totaling more than $25,000.
The good news: He bragged about his fund-picking prowess. The bad news: He had to pay taxes on the unexpected windfall. While paying the 15 percent, long-term capital gains rate was certainly better than forking over even more taxes at the higher bracket into which the investments pushed him, the surprise tax bill still caused a substantial dent in his bank account.
Fund moves are tax sales
Don't overlook the tax consequences of reallocating your mutual fund holdings. Some investors are shocked to discover that when they move assets from one fund to another, even within the same fund family, the IRS considers this selling.If there's a gain associated with this fund shift, it's taxable at either the short- or long-term rates (or a combination of both) depending on when you bought the first fund shares.
So pay attention to your funds and all your portfolio management actions throughout the year. This will give you time to prepare for or ease any impending tax burden.
More importantly, it could help prevent any penalties that might come from not paying enough taxes in payroll withholding contributions. To avoid a tax underpayment penalty caused by capital gains -- either via stock sales or fund distributions -- you might want to adjust your salary withholding or make estimated tax payments when you see the value of your portfolio increasing.
Investing tax strategies
Other than more accurately forecasting what your ultimate capital gains tax bill might be, is there anything the average investor can do to ameliorate a capital gains tax burden?The easiest move is maximizing tax-deferred investments. Taxes aren't due on IRA or 401(k) plan distributions for years -- or, in the case of Roth IRAs, ever.
If you've maxed out your retirement accounts and have some taxable stock holdings, Mark Mayad, managing director at Mayad Enterprizes and formerly a principal with Concorde Investment Management in Dallas, suggests timing your sales over an extended period. This will spread the gains, and their taxes, across future tax years.
As for mutual funds, Towson University accounting professor Seth Hammer advises his clients, who include members of the NFL's Baltimore Ravens, to look at index funds, which have a low turnover ratio. Turnover ratio, Hammer explains, is how often the fund trades its investments. More trades mean more opportunities for capital gain distributions to be passed along to the fund holder.
Richard Bregman, president of MJB Asset Management in Manhattan, acknowledges that in the end, there's "not a heck of a lot you can do" about capital gains taxes. But investors can save themselves some aggravation if they examine a fund's tax potential before investing.