Why I Had a Tax Surprise, and How I Hope to Avoid it in the Future
A couple years ago, I paid a lot of tax (for me) on gains from an investment I didn’t sell.
Why? Because I owned mutual funds in a taxable account. And not just any mutual fund. I owned one that paid a huge capital gain distribution. Gains are good, right!? For me, it wasn’t quite that simple.
Here’s the quick background, followed by my takeaways.
As a kid, Grandpa gave me one piece of financial advice that stuck: pay yourself first. Every month, before even paying rent, the car payment, or utilities, put something aside for you. The amount wasn’t important. His advice, I think, was about forming good money habits from an early age.
So that’s what I tried to do. I treated saving and investing as my most important monthly expense. As my income grew, so did my monthly savings. Eventually, I automated it, sending a certain percentage of my paycheck to a separate investment account and had those dollars automatically invested in a growth-oriented mutual fund.
That carried on for years.
During 2021, I made no changes to the account. No buys. No sells. Nothing that would trigger a taxable event.
It didn’t matter.
Mutual funds are required to distribute realized gains to shareholders each year. This typically happens in late November and early December. Unless they have enough losses to offset the gains, those shareholders will owe tax on the distributions.
And in 2021, the fund I owned realized lots and lots of gains.
So, in April of the following year, I had to pay a big tax bill[1] that wasn’t in my plans.
What is the takeaway? I wanted more control over when and how I pay tax. When thinking about taxable accounts, it could help to consider three things: style, structure, and strategic selling.
STYLE
This is referring to the style of management – active vs. indexed.
In taxable accounts, index funds typically give investors more control over the timing of taxes.
Actively managed funds generally try to beat an index over a full market cycle, either by delivering higher returns, lower risk, or both. Index funds, on the other hand, generally charge lower fees and try to mimic the returns of the specific index. Own an S&P 500 index fund? Your performance should look nearly identical to that of the index.
In my opinion, both styles can have their place in a portfolio.
Active managers routinely make buy and sell decisions, usually based on their estimate of a stock’s value compared to the current price. Unless minimizing taxes is explicitly part of the strategy, a fund manager’s obligation to shareholders is to deliver returns in line with the objectives outlined in the prospectus, regardless of tax consequences. That trading can make active mutual funds less tax-efficient than their index counterparts, for the reasons I mention above. As gains are realized, shareholders receive those distributions and must pay capital gains taxes.
Since the index funds mimic the underlying benchmark, which makes very few changes to its holdings, trading is rare. Gains are most commonly realized when the end shareholder (you or I) makes a decision to sell.
A newer style of indexing is called custom or direct indexing. I’ll use the S&P 500 to help illustrate.
If I own an S&P 500 Index fund, the fund will invest in each company within that index. But I own the fund. My investment shows up as a single line item on my statement. As an example, I could own the Vanguard 500 Index Fund (VFINX).
Direct indexing takes a different approach by owning a broad sample of the individual companies within the index. Instead of owning the fund, I would see shares of Apple, Microsoft, Amazon.com, etc. on my statement. There could be several hundred holdings. The manager actively looks for opportunities to sell those stocks that are down, realizing losses that can be used to offset future gains. The primary goals[2] are to deliver index-like returns in a more tax-efficient manner. These strategies could have significant benefits for high-income investors with large pools of taxable investments (i.e. not in IRAs, 401k’s, etc.). However, performance will likely deviate from the underlying index as customization and tax loss harvesting are introduced into the strategy, potentially weighing on returns.
STRUCTURE
Most investors have access to a variety of structures like mutual funds, exchange-traded funds (ETFs), or individual stocks and bonds.
Mutual funds may be great options for the right investors. I don’t want to give the impression that mutual funds are inherently “bad” because of how they pass through gains and losses. Rather, it’s more about awareness and owning them with the right expectations. Every structure has pros and cons.
ETFs give investors much more control over the timing of tax liabilities. ETFs have an inherent advantage over mutual funds in how they handle gains and losses, the details of which are too lengthy to cover here. For those interested, Morningstar has a nice summary.
Until recently, the ETF marketplace had been dominated by index-tracking strategies. A combination of ultra-low fees and tax deferral made for a powerful and attractive combination. Active managers have started to join the party, though, giving tax-sensitive investors additional options worth serious consideration. Separately managed accounts (SMAs), which I haven’t mentioned until now, can be a more tax-friendly structure as well, but it largely depends on the individual strategy. The required minimum investments also tend to be much higher for SMAs.
Generally, individual securities stocks and ETFs give investors more control than mutual funds, at least when it comes to realizing gains and paying tax.
STRATEGIC SELLING
In my example of paying unwanted capital gains tax, I would have preferred to defer those gains until later. Or wait until a poor year for the market when capturing losses could have cushioned the tax blow. Perhaps a low-income year was on the horizon, or liquidity to pay the tax bill could have been better. You get the point.
Most investors prefer to pay as little tax as possible. Tax loss and tax gain harvesting can help investors be more intentional with the timing of tax payments.
Tax loss harvesting was a popular topic last year. Most asset classes – stocks, bonds, real estate, etc. – were down for the year. It was a great opportunity to sell while prices were down, capturing the losses to offset future gains and defer taxes until some point down the road.
Harvesting gains get less attention, but it could prove to be just as valuable if income is abnormally or temporarily low. Taking advantage of lower brackets by realizing gains could make sense for the right individuals. We wrote about this a couple weeks ago here, specifically as it relates to taking advantage of a 0% capital gains tax bracket.
SUMMARY
In the world of investing, there are only so many things we can control. Taxes, at least to a certain extent, are in that group. Taking time to thoughtfully choose the best style and structure could make the difference between paying taxes on your terms.
You can email me at eric@divviwealth.com or set up time with the Divvi team to continue the conversations.
