Two months and counting and we can finally say good-bye to 2008. During 2008, we have seen more 100+ point moves in the markets, both up and down days. There were also a large number of days where the intraday move exceeded 100 points. The final two months may continue this type of volatility. While this may be frustrating or worrisome, it is also the time of year where most mutual funds declare and pay their dividends and capital gains for the year. For retirement accounts, this is not particularly an issue. However, for taxable accounts, this may add hundreds if not thousands to your income tax bill for the year.
As I have said before, 2008 may be a year where many equity funds distribute a capital gain dividend even though their overall performance is down for the year. This occurs when fund managers are forced to sell long-term holdings that represent large gains. If the recognized gains exceed the recognized losses during the year, then the fund must distribute at least ninety percent of those gains prior to the end of the calendar year. However, it is possible many of the funds also have recognized significant losses due to the extreme moves in the markets and thus may not pay a capital gain. Fortunately, this is something most mutual funds are willing to provide advance guidance for their shareholders.
As investors, a review of your taxable portfolios and the large mutual fund holdings within each should alert you to potential problems. Capital gain distributions can exceed one or two dollars per share depending upon the fund. While losses can still be recognized during the remainder of the year and thus offset large capital gain distributions on the federal Schedule D form, there is no such offset on the Tennessee return.
With a phone call to the mutual fund office, you should be able to determine when capital gains will be distributed and the record date. This is the date the fund uses to determine which shareholders will receive those distributions. In some cases, there may be a few days between the record date and the payment date. So, it is more important to know the record date. If it is advisable to avoid the capital gain distribution, then the shares must be sold prior to the record date. The fund managers may also be able to let you know when an estimate of the distributions will be available.
Depending upon the amount of interest, dividends, and distributed gains, the total may exceed Tennessee's exempt income limit and thus show taxable income for Tennessee. Six percent (6%) of the amount of income exceeding the exemption is due in tax. The exempt income is $1,250 for single filers and $2,500 for married filers filing jointly.
It is important to understand and know all of the tax rules governing sells, recognition of gains as well as losses, state taxable income, and the true tax impact of actions taken. If this is not your area of expertise, then I would suggest finding an advisor who is clearly knowledgeable in this important area. As most of you know, what the IRS giveth, they can also take away. There is a rule called 'wash sale', and this rule disallows a loss being taken when the same asset is repurchased within 30 days. Thus, it is not advisable to sell a mutual fund to avoid the capital gain distribution when it is your intent to immediately purchase it back. The recognition of the loss is disallowed, so one of the benefits of selling is lost. If you plan to stay out of the fund for the 30 days, then you are also out of the market for that period of time. Potentially, any benefit gained from avoiding the capital gain distribution may be lost, if significant moves to the upside occur in the market while you are sitting on the sidelines.
Tax planning and management is not for the amateur. There are other factors to consider and potentially other solutions which can be implemented. My intent today is to alert you to the potential tax liability looming in the days ahead as each fund takes steps to determine the distributions they will be required to pay during 2008.
If you need assistance in managing your investments and how they may impact your retirement, taxes, and estate planning, it may be time to seek a CERTIFIED FINANCIAL PLANNER™ (CFP). There are several in our area and you can locate them through two websites: www.cfp.net/search and www.fpaforfinancialplanning.org.
HOW TO REACH THE WRITER: 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.