Mutual Funds and taxes

[gregintenn]

We've gotten to the point in investing where we have the odd year that capital gains from the sale of stocks inside our mutual funds eats our lunch in taxes. Doesn't happen every year, and since we don't itemize, I can't ever claim the odd years where we experience capital losses.

It looks to me like this is really starting to eat into what it appears we're earning in these mutual funds. I'm trying now to lean more toward funds with low turn over ratios. Wouldn't that help some?

Got any other suggestions?

[vonna]

I have definitely been working on trying to make our taxable accounts more tax friendly. When I first started investing, I thought "diversification" meant lots of funds from different fund families

Also, we didn't have much tax sheltered room to invest, because the TSP wasn't offered in the military for the first 15 years of our careers.  We took full advantage of Roth IRA's along the way, then TSP once it was offered, but by far the bulk of our portfolio is in taxable accounts.

Here is what I have been doing to try to make things more tax friendly:

1) I stopped automatically investing dividends and capital gains.  No sense in making our tax-unfriendly funds larger than they already are!  VGHAX (Vanguard Healthcare) has been very good to us, but not so much in the tax-friendly category.  By no longer investing the generous capital gains, at least we are controlling the future growth a bit. 

2) We set up a "sweep account" for all dividend/cg distributions, and now manually make a decision as to what to do with them.  We still reinvest the bulk, but now usually in VTSAX (Vanguard Total Stock Market), or VTIAX (Vanguard Total International Stock) -- which is much more tax friendly for us.

3) We now gift shares of mutual funds instead of cash to charity as another means of gradually changing our taxable portfolio in a tax friendly way.

Definitely a work in progress, but we are getting a bit more tax efficient each year.

Also, I don't understand your statement about having to itemize to write off your capital losses.  Capital losses are on the first page of the tax return -- no need to itemize to take advantage.

[gregintenn]

Also, I don't understand your statement about having to itemize to write off your capital losses. Capital losses are on the first page of the tax return -- no need to itemize to take advantage.

I did not know this. Thanks.

[Deleted]

Struggling with this as well Greg, we only started investing in a taxable account in 2012 and stick to the total market index funds, total US, total International, and a managed muni bond fund. We are going to have an absolute tax nightmare in retirement and trying to legally avoid it as much as possible.

The bogleheads wiki on principles of tax efficient fund placement is a great resource:

www.bogleheads.org/wiki/Principles_of_tax-efficient_fund_placement

[spartan7886]

gregintenn

I looked up as well about the standard deduction affecting it. It does appear that you need to fill out the 1040 long form, not 1040A or 1040EZ.

If you filed incorrectly by not taking a capital loss you should have, you should look into a 1040X for the years you can. That would be 2014 taxes, 2013, and 2012 (as long as you do it before April 15).

[taxref]

Based on the messages above, its clear that there is a great deal of misunderstanding regarding the tax treatment of capital gains and losses.  Some of the basics follow.

On your tax return, capital gains/losses are reported on Schedule E.  Itemizing deductions has nothing to do with claiming capital losses.

If there is a net capital loss for the year, that loss first serves to reduce capital gains for the year.  If CLs exceed CGs, up to $3K of the CL can be used to reduce ordinary income on the 1040.  Losses in excess of $3K are carried forward to future years.

That loss carry forward is then treated the same way the next year (ie: it reduces capital gains, then up to $3K ordinary income, then is carried forward to future years).  

I would encourage some in this thread to take their past year returns to a professional ASAP (the SOL for 3 years ago expires 4-15-16).  An amended return can be filed to claim the losses, and to establish the proper loss carry forward amount.  You also need to learn the real rules of taxes on investments, as some seem to be going off in very wrong directions.  See a professional. 

[gregintenn]

Thanks for the advice guys.

I didn't say what I meant at all after rereading my original post.

I did know how capital losses worked, except I did not know about the carried forward and the 3k parts.

What I meant to say was that in mutual funds, if I understand correctly, you pay tax on capital gains inside these funds yearly.

You don't pay taxes yearly on the increase or decrease in value of these funds, but when you sell them.

Am I on the right track so far?


What sucks is that a particular mutual fund can lose a substantial amount of value in a given year, yet you still may have to pay capital gain taxes.

Sorry for the confusion.

I have sold single stocks in the past, but have not yet sold mutual funds. If I'm wrong about any of this, I would appreciate your correction.

[Deleted]

Are you talking about dividends?

[gregintenn]

Jan 17, 2016 17:02:06 GMT -5 oped said:

Are you talking about dividends?

I don't believe so. You pay taxes on dividends as well. I don't recall seeing a negative dividend. I have my dividends reinvested, so it works the same as buying mutual funds.

What I'm trying to say is that it sucks when your net worth shrinks due to mutual fund values, yet you still may owe taxes on capital gains tax because of the sale of select stocks inside the fund.

[Deleted]

Jan 17, 2016 17:02:06 GMT -5 oped said:

Are you talking about dividends?

No, dividends are different.

Mutual funds sell stock on an ongoing basis, just as private investors do, if they think a stock has hit its peak or they want to get rid of a loser stock and buy something else. It gets more complicated with mutual funds when investors decide they want to sell their shares of the fund (and Stupid Money tends to do this in down markets) and the mutual fund is forced to sell more shares to raise the necessary cash.  So, these are realized gains or losses and the fund is required to report your share to you every year and yes, it sucks. It's even worse when the fund is actually down for the year because of a lot of unrealized losses but yes, it sure happens.

Some ways to protect yourself- first, as you noted, keep funds with low turnover ratios in your after-tax accounts.  You can also check a mutual funds' return figures before and after tax since I think they have to show both.  Of course, the tax bracket they assume may not apply to you.  If you like a fund but it's got high turnover, buy it in an IRA.  One of the big disadvantages of an IRA is that withdrawals are taxed as ordinary income.  If they're all short-term gains anyway, it doesn't matter.    

I'm not a CPA, but I've been dealing with this for years.

[gregintenn]

Thank you Athena. This is the type advice I was looking for.


You made me think of another question.

What is the reasoning for short and long term capital gains being treated differently? This stuff is getting confusing to me.

[Deleted]

Jan 17, 2016 18:53:00 GMT -5 gregintenn said:

What is the reasoning for short and long term capital gains being treated differently? This stuff is getting confusing to me.

My guess is that it was to encourage long-term investing in companies instead of frequent trading.  Back before discount brokerages, it was especially important because commissions were high and the transactional costs of too much buying and selling really cut into your investment results.  It's also a good way to get wiped out.  There are too many huge firms out there with more people, fancier models and more expensive information, so day trading or other trades to make short-term gains on a regular basis is risky for individual investors.  Short-term investors are also more likely to freak out and stocks at the first sign of bad news, adding to market volatility.

[Deleted]

Thanks Athena. I was just confused by what Gregg was saying for a minute

I would guess this would be more an issue with more actively managed funds...

[gregintenn]

Jan 17, 2016 19:46:53 GMT -5 oped said:

Thanks Athena. I was just confused by what Gregg was saying for a minute

I would guess this would be more an issue with more actively managed funds...

Sorry, oped. Greg was confused as well.

[Deleted]

One thing that slightly alleviates the misery: the tax basis of the mutual fund is increased by the value of the capital gains distribution, Let's say you buy it for $10,000 and it immediately declares a $2,000 capital gain distribution. Of course you have to pay tax on the gain in that year, but when you sell it, your gain or loss is calculated as if you paid $12,000, not $10,000 (assuming no more distributions).

It used to be a PITA to calculate the revised basis (I've held some mutual funds for 15 years), but now the brokerage supplies it and calculates the taxable gain/loss when you sell.

[gregintenn]

Jan 17, 2016 23:18:15 GMT -5 @athena53 said:

One thing that slightly alleviates the misery: the tax basis of the mutual fund is increased by the value of the capital gains distribution, Let's say you buy it for $10,000 and it immediately declares a $2,000 capital gain distribution. Of course you have to pay tax on the gain in that year, but when you sell it, your gain or loss is calculated as if you paid $12,000, not $10,000 (assuming no more distributions).

It used to be a PITA to calculate the revised basis (I've held some mutual funds for 15 years), but now the brokerage supplies it and calculates the taxable gain/loss when you sell.

Yeah. As I said, I once sold some single stocks that were purchased monthly for a period of years. I had to calculate my basis for those. Between that, spin offs, and stock splits, I sent that return in in a shoe box.