The investment rollercoaster that has occurred this year most likely has caused a number of transactions to occur in your investments account. Since a gain or loss in a retirement account is not reportable on the annual tax return, it will be the transactions that occurred in taxable accounts that we will be discussing.
Depending upon how taxable accounts were managed this year, it may be wise to review the status of the recognized gains and losses. When market corrections occur like they did during this recession, mutual fund managers often sell holdings that have been long term positions in the fund. This action can cause a mutual fund to have recognized gains that must be distributed in accordance with IRS rules. Thus, even when the fund has lost value during a year, it is possible for each shareholder who still owns the shares when distributions are recorded to have reportable income in the form of distributed dividends and gains.
Clearly, this can add insult to injury if a shareholder has to pay income taxes on an account that has lost value for the year. Thus, it is important to monitor the status of distributions for 2009 and be prepared to take appropriate steps when a fund may be paying higher than normal distributions for the year.
For mutual funds, each time the fund pays a distribution and the distribution is reinvested into the fund, this increases the tax basis in the fund. Because the distributions are reported as taxable income in the year they are paid, part of the increase in value in the fund has already had the income taxes paid. Due to the payment of taxes on the reinvested distributions, it is possible for a fund that has increased in value over the years to be sold and a loss taken. Here is an example:
$10,000 is invested early in 2005. In each year, the fund paid and reinvested $500 of distributions. These occurred from 2005-2008, thus $2,000 was reinvested through the dividends received since the start. For tax purposes the basis is now $12,000. Due to the market the investment is worth $11,700 and the fund is planning on paying $200 in distributions in 2009. If the fund is held, $200 of income will be received and must be reported as taxable income. Since the $200 is already part of the fund’s value, after the payment and reinvestment, the value of the holding will still be $11,700. If on the other hand, the fund was sold and the $11,700 was invested in a new fund, the $200 dividend would not be received and thus there would not be any reportable income. Secondly, when the fund was sold for the $11,700, a $300 loss could be taken on the tax return since the basis was $12,000 thus reducing the taxes due for the year instead of having to pay additional taxes.
When individual securities are in the account, similar tax strategies must be employed to manage the tax impact of these securities as well. If during the recent declines new positions were added to your account or additional shares purchased while a company’s stock was severely discounted, it may be appropriate to manage these gains and losses as well.
The Internal Revenue Code has rules that must be followed when selling individual stocks in order to manage the tax impact. This is especially true when there have been several purchases and all at different prices. Specifically, when a sale is made, the seller must document at the time of sale, not at the end of the year, which shares were sold. Due to the extreme declines and recoveries in the market, there may be a number of holdings requiring management prior to the end of the year.
Investment performance does not stop with the selection of the fund or stock. The long and short of investment management and performance is how much is left once the holding has been sold and the taxes are paid. Clearly, proper management of holdings can reduce the taxes that are paid each year. But to achieve the correct answer or determine the proper steps, a great deal of time is required to study each holding, knowledge of the tax basis, as well as potential upcoming distributions.
I am still amazed at the number individual investors who believe it is less costly for them to manage their own investments, something that may represent 25 percent to 70 percent or more of their entire net worth. But, they will drive their car through a quick-lube station and pay around $25 to have someone else change the oil in their car.
For help with managing investment assets, contact me at Quality Financial Concepts or one of the other Certified Financial Planners in our area. To continue a personal quest for education, view our website, www.goqfc.com. You will find articles on a variety of topics, on-line seminars, calculators, and a host of other tools.