How to Avoid an Extremely Unpleasant Tax Surprise from Your Investments

Many investors that hold mutual funds outside of a tax-advantaged account such a 401(k) or Roth IRA are going to receive a rude awakening when their broker sends them their year-end tax documents. Average people that experienced losses of 30%, 40%, and even 50% or more are likely to find that they owe capital gains taxes on these losers. Don’t think it’s possible? Unfortunately, due to the way mutual funds are structured, it’s a simple reality that many new investors don’t even understand.

A mutual fund is nothing more than a pool of assets overseen by a professional money manager. Tax rules state that the fund needs to pay out its dividends, realized capital gains, and other income to the mutual fund owners each year on a pro-rata basis. Many funds, particularly those with disciplined management teams that like to hold long-term positions, are able to avoid taxes for years because they buy shares of businesses and simply park them in the bank vault. This allows them to keep more money working for their fundholders. The result is years, sometimes decades, of unrealized capital gains that increase the value of your mutual fund’s share price but don’t ever get distributed – and thus, you never pay taxes on them.

In the total panic that occurred over the past twenty four months as the credit crisis swept through the financial community and into the broader economy, something unexpected happened. Average investors, unable to handle the stress of double-digit price fluctuations, dumped their mutual funds en masse. This forced the professionals that managed these funds to sell off stocks that they knew were worth substantially more than the current market price in order to come up with the cash for those who wanted out of the fund. When the redemption fees became overwhelming, many of them were forced to sell off shares of those long-term winners that had huge unrealized capital gains. Despite experiencing huge losses for the year, the gains on these long-term securities were often substantial. As the redemptions flooded in and the shares were sold, the gains became realized triggering – you guessed it – the capital gains tax.

To illustrate the concept, let me use an example. Imagine that I managed a mutual fund called Super Value Fund 500. More than twenty years ago, this fictional fund invested in the Microsoft IPO. We turned a $500,000 investment into $500,000,000 for an unrealized capital gain of $499,500,000. Now, we have never sold any of the stock so there have been no taxes paid on that gain. If we were to sell the stock and distribute the gain of $499,500,000 to our mutual fund shareholders pro-rata, they would each be responsible for their own taxes. Those that held their investment through a retirement or tax advantaged account would owe nothing, but those that had their shares held through a regular brokerage account would be subject to the capital gains tax (currently 15% as of the time of this article). They would also owe State taxes on top of that.

As manager of the fund, I may have no intention of ever selling that stock. If the market crashes and fundholders panic, however, I’m going to be forced to come up with cash to redeem their shares. As a result, I may be forced to sell some of that Microsoft stock, triggering huge, built-up capital gains taxes. The horrible part is that if you had bought your stock a few weeks before this decision were made and the distribution paid out at the end of the year, you would effectively be paying more than 25 years of investment tax for someone else that got to cash out scot-free. So, you not only get to watch your holdings collapse as the market falls, but you get to pick up the tab for someone else who experienced a quarter-century meteoric rise in the software company.

What’s really unfortunate with the whole situation is that the men and women who do exactly what history has proven works, that is continue to dollar cost average, reinvest dividends, and focus on strong quality assets, were punished for the stupidity of others. That’s why it’s important to protect yourself before something like this happens. How? By following two simple rules.

* Never buy a mutual fund before a distribution unless it is through a tax-free account.

* Never buy a mutual fund outside of a tax-free or tax-advantaged account such as a 401(k), Roth IRA, SEP-IRA, Simple IRA, Profit Sharing Plan, et cetera unless you are willing to take the risk of huge tax payments.

Follow those two guidelines and you’ll at least have a fighting chance of avoiding unfair capital gains taxes.

Rodney Gilbert, CLTC, is a Registered Financial Representative and President of United Life Financial LLC. Rodney has been assisting his clients achieve their financial objectives since 2007. He holds Series 6 and Series 63 licenses and the Certification in Long Term Care (CLTC) Designation. Rodney is also an avid speaker to those who want to learn more about tax planning with IRAs. For additional information, visit http://www.unitedlifefinancial.net/


Remember, this blog is for information only and is not an offer to sell or invest in securities. Please refer to all appropriate prospectuses prior to any investment. Investments can, and do, lose money.