The Taxes You May Be Paying on Your Investments

Depending on what you invest in, this may be a year where you both incur a loss of portfolio value and owe capital gains taxes. This is particularly true if you hold actively managed mutual funds in a taxable account. Even if you don’t hold mutual funds in a taxable account, the new tax law may have implications for you.

I’ll start with mutual funds. In an email sent out last week, Mark Wilson of CapGainsValet wrote, “We are breaking records (going back to 2014) for funds with 10%+, 20%+ and 30%+ distributions.” As of today, Wilson has counted 67 funds with estimated distributions in excess of 20%. Put another way, for every dollar of share assets, investors in these funds will receive distributions equating to $0.20 or more. The distributions are taxable if shares are held in a taxable account, even if the fund has declined in value and/or you’ve only held the fund for a short period of time.

The large distributions are the result of the long-running bull market. After a nearly 10-year bull run (though wobbling as of late), managers of actively managed funds have fewer losing positions to sell. At the same time, longer-term positions that no longer matched their strategies were more likely to have increased than decreased in value.

This put fund managers in a position where the only choice when it came to making a portfolio change was to sell a winner without having enough losses to offset the tax impact.

Some of you may be able to avoid paying taxes on the distributed long-term capital gains, and similar gains on other investments. The Tax Cuts and Jobs Act established a 0% tax rate on capital gains (and qualified dividends) up for married couples filing joint returns with taxable income up to $77,200 ($38,600 for single filers). Note the income limits; previously, the 0% rate applied to those who were in the older 10% and 15% tax brackets.

Capital gains and dividends count toward your adjusted gross income. Depending how close you are to the next bracket and the size of the capital gains realized, you could potentially face the double-whammy of paying a higher marginal tax rate and a higher capital gains rate. For those of you who are retired, capital gains can also impact how much of your Social Security benefits are taxed this year and what you will pay in Medicare premiums two years from now if they push you over certain thresholds. Adding Roth IRA conversions to the mix will also increase the odds of getting near or going over the thresholds for both working and retired investors.

Those of you with higher income levels will also face the possibility of paying the 3.8% net investment income (NII) surtax on capital gains and dividends. The tax applies to joint filers with NII and modified adjusted gross incomes above $250,000 and single filers with NII and modified adjusted gross incomes above $200,000. These thresholds are not indexed to inflation.

Gains can be offset by losses. To the extent there are losses to claim, you can not only negate a similar amount of gains but also reduce your adjusted gross income by up to $3,000 per year. You can also reduce gains when selling securities or fund shares if you tell your brokerage or mutual fund firm in advance which specific shares you want to sell.

At AAII, we do not believe the tax tail should wag the portfolio dog. Rather, we think you should make the best investing decision first and then deal with tax consequences afterward. There is a good amount of flexibility within this framework for those using both taxable and tax-preferred accounts. Tax-efficient assets such as index funds, long-term stock holdings and municipal bonds should be held in taxable accounts. Actively managed funds, corporate bonds and real estate investment trusts (REITs) should be held in traditional IRAs, Roth IRAs, 401(k)s and similar types of accounts. A simple rule of thumb is to hold the least tax-efficient investments in accounts not subject to capital gains and ordinary income taxes.