Money Matters: Year-end tax planning can be beneficial at mid-year

Hint of fall arrived this week with cooler morning temperatures. High school as well as college football players are gearing up for the season. School zones are flashing once again. There is nothing happening that says it is time to do year-end tax planning. But, when investment markets have been like they have been lately, taking time to review your accounts now can be beneficial.

When the markets are whipsawed from one end to another, mutual fund managers often sell portions of long-term holdings to take some profits off of the table. These sells create gains that mutual fund companies are required to distribute to the shareholders.

While there is hope of a firming economy and thus a recovery in the market, 2008 may be the first year in several where investment values are down. The combination of lower year-end values and distributed dividends by the fund companies creates a very undesirable event.

This combination creates a negative return on your investments, and yet taxable income that must be reported to the IRS on the tax return. Not a very pretty picture. It has been a number of years since this has occurred, but it is a common occurrence when mutual funds are part of the portfolio.

When a purchase is made in a mutual fund, the basis in the shares is of course, the purchase price. But, regardless of the time of the purchase, the fund will always have holdings inside the fund that already have a gain or a loss when a purchase is made.

If a fund manager sells shares and recognizes a profit, that profit is paid out to all of the shareholders in the form of a capital gain distribution. Even it the gain was earned prior to the date of your purchase, you still have to report the dividend as income for taxable accounts.

In difficult years such as this one, it is not uncommon to experience the following. A mutual fund purchase is made at $24.00 per share and is worth $21.24 at the end of the year. Even though it is worth less, a dollar or more per share of dividend income can still be paid prior to the close of the calendar year. To add insult to injury, all dividends from mutual funds including capital gains are also taxed by Tennessee.

The question becomes, are there steps to assist in managing the tax bite these taxable investment accounts may create? During the remainder of the year, you should review the capital gains and losses you have already “realized” for the year. To do this, you should add the capital gains that have already been paid by mutual funds and determine when gains are to be paid during the rest of the year. Once you know your tax impact from these gains, a review of your portfolio should take place. If you currently have substantial gains, you should look to see if there are any positions if sold could help offset these gains. This includes mutual funds as well as stocks.

For mutual funds, there are two important numbers you should track. The first is the amount of money you placed in the fund. You will add to this amount if you make additions to the fund and subtract from this value the amount of any withdrawals you take from the fund. This is the easy way to see if you are up or down in a fund by comparing this “net invested” amount to the fund’s value.

The second number is the tax basis. This starts out being the amount you originally invested in the fund, but then it is adjusted for any reinvested dividends or capital gains, as well as for any sells. It is very possible for the fund’s value to be higher than the net amount invested, thus you have made money; but for the tax basis to be even higher due to all of the reinvested dividends and thus if the fund was sold, you would have a tax loss to take on your tax return.

If you have a fund in your portfolio that you have determined will pay a high capital gain dividend later this year, it may be wise to consider selling the fund. Selling the shares will avoid the dividend and thus the Tennessee taxable income, but still locked in the gain on the holding. Capital gains from the sell of shares are not taxed by Tennessee, but distributed gains are. Careful attention must take place when reinvesting those funds so you do not purchase a new fund that will be paying a dividend just days or weeks after you purchase shares.

Professional managers such as QFC or others will track this number and can assist in making these decisions to help manage the tax impact of their clients. So, do not miss this important opportunity to manage the potential tax impact your taxable investment accounts may create.


Would you like a response to a financial question? Send your question to Doug Horn, 115 W. Broadway, Maryville, TN 37801. Be sure to mark your envelope Money Matters.

Doug Horn, CFP, is an area financial planner with more than 24 years financial experience and founder of Quality Financial Concepts, located in downtown Maryville on Broadway.

Doug Horn, CFP, Registered Investment Advisor in Tennessee and Texas and Registered Principal, Branch Office of and Securities offered through CUE Financial, Member FINRA, SIPC.

© 2008 All rights reserved. This material may not be published, broadcast, rewritten or redistributed.

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