One Downside of mutual funds, especially in taxable accounts, is the distribution of potentially large dividends at year end with taxable implications. In this episode, we discussed a few ways of avoiding nasty tax surprises that can happen.
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Speaker 1 (00:07):
Welcome back to 30 Minute Money, the podcast that delivers action oriented smart money ideas and bite-sized pieces. I'm Scott Fitzgerald at Roc Vox Recording and production. My compadre, Steve Wershing from Focused Wealth Advisors.
Speaker 2 (00:20):
Hey Scott, nice to see you.
Speaker 1 (00:21):
Nice to see you again, sir. And it's, whenever we do this podcast, it's always like I get the list of what we're going to talk about and every once in a while I can make a comment about how you title things and I always just avoiding the rude surprise of mutual Fund dividends. That's right. There's a whole comic book that has just appeared in my head with a rude surprise of mutual fund dividends. But I'm
Speaker 2 (00:47):
Interested to get into this. Well, my next financial book's going to be a graphic novel, so Oh, perfect. I think that fits. Yep.
Speaker 1 (00:53):
Tax man, no one likes him. Yeah,
Speaker 2 (00:56):
Exactly. He's the villain actually.
Speaker 1 (01:01):
Alright, so what do we got here today?
Speaker 2 (01:02):
Well, so it's around the end of the year. We'll probably put this up around the time when this is actually happening. And so I thought a timely topic for folks, and that is that if you hold mutual funds, there are a lot of good things that we'll want to talk about. But one of the bad things is you can get surprised with a big tax present at the end of the year, which none of us wants to see, and it comes in the form of year end dividends. So I wanted to talk about that a little bit. Now, first I should say I love mutual funds. Mutual funds are great. Mutual funds are terrific instruments. They are, if you're not familiar with how mutual funds are put together, they're pooled investments. So instead of going out and buying a bunch of individual stocks and a bunch of individual bonds, you put your money into a pool with a whole lot of other investors and they invest the money in the pool.
So now you're not talking about a few thousand dollars or tens of thousands of dollars, you're talking about tens of millions of dollars or hundreds of millions of dollars. So you could put a little bit of money into a mutual fund and you can get broad diversification, you can do it inexpensively, you can get professional management. I mean, there are all kinds of really good things about mutual funds and there are some downsides. I think the big downside to mutual funds is the issue of dividends, especially at the end of the year. Here's where they come from onto the regulations that create mutual funds. There's a rule that says that whatever profits you make, whatever interest you get, whatever trading profits you get, whatever dividends you receive from the things in the portfolio, you have to distribute something like 98% of those by the end of the year.
You can't hold them in the portfolio, you have to send them out to the people who own the mutual fund. And typically mutual funds will do, especially the capital gains one once at the end the year probably in the first two weeks of December. And so that sets up the situation where if there's been a lot of activity, if there's been buying and selling in the portfolio, then that manager is going to have to distribute all those profits at the end of the year. And you may not be expecting it. So you may think you have your taxes nailed down, you've got a real good idea of where you're going to be and how much is coming in, how much tax you're going to have to pay. And then boom, you get this big thing. You get this 10 99 in the new year saying, wait a minute, I didn't. What do you mean I made an extra 15 or $20,000 that shows up on your 10 40 form? And so that, I don't
Speaker 1 (03:36):
Think I'd be upset by that, but I see where you're going
Speaker 2 (03:39):
With that. Yeah, right, exactly. Well, and where it can really be an unpleasant surprise. Now you're saying that you probably wouldn't be upset about that because you were probably watching your account go up and up and up through the year. And so okay, I have to pay a little bit of tax on all this, right? Yeah. But there are other situations like when the market is really volatile and it goes up a lot and down a lot in a year, the manager may be buying and selling things through the year to take advantage of opportunities, but also to protect the portfolio. If that manager believes that a bunch of things are starting down and they're going to go down, they may sell that a lot of that to protect the portfolio, but if they sell them at a profit, you're going to have to pay tax at the end of the year.
And so you can get into this weird situation where what you had in the account was less at the end of the year than the beginning of the year, but you have to pay tax on all these profits. And a lot of people look at that and say, wait a minute, my account was down. What do you mean there are no profits? What do you mean profits I have to pay tax on? And it's because of the trading that goes on during the year, so you can get in and if the manager had not sold those things, your account might very well be down a lot farther than it was, but you set up this thing that we call phantom income, which is your account may have gone down a bunch over the course of the year, but then you get this form that says you got to pay tax on all these profits at the end of the year.
And that just puts salt in the wound. That just adds insult to injury. Now, if you have money in IRAs, it's no big deal because whatever happens in IRAs, IRAs are a little like Las Vegas. Whatever happens in the IRA stays in the IRA doesn't show up on your 10 40 form. But if you have mutual funds in a taxable account, then you can get this. But especially if you have some fairly large positions or positions in which you've got a lot of built up capital gains, there are some things that you can do to get around that. And so I just wanted to mention those because if you've got a large portfolio and you get these unpleasant things at the end of the year, well, there are some things that you can do to sort of head those off.
Speaker 1 (05:47):
So getting kind of back to more basics, dividends, from my understanding what I learned in school dividends when you've got a stock and at the end of the year they say, Hey, the company just made X, Y, Z profits, and so here's your 25 cents that you won, that you got. Obviously with the real investors, they get more net, but that it's something that comes out once a year that is based on the performance. So I understand that part of it when you're talking about mutual funds and the mutual funds are essentially a long-term type of investment. Typically you get these mutual funds and you just want it to grow. And so I didn't even realize that they did return things in a way that I thought you only had to pay taxes on it and when you sell it and sell it at a profit. So that's interesting.
Speaker 2 (06:46):
Yeah, so you are correct. A dividend is a distribution of profit. So if you have a company and the company is profitable and they keep a little bit of that profit in the company to continue building the company, but then the rest of it they distribute to shareholders, that's a stock dividend and that's a distribution of the profits. With mutual funds, it's the same thing. A dividend is just a distribution of profits. And so like I said, under the regulations, if mutual funds realize those profits, they have to distribute virtually all of them to the shareholders each year that they realize 'em. So it's the same idea. It's just that a company makes money by making products and selling them, and a mutual fund makes money by buying and selling stocks or buying and selling securities, that kind of stuff. So still distribution of profits, this idea is the same.
So there are a couple of ways of getting around that. One is that you can use exchange traded funds as opposed to mutual funds. Exchange traded funds are very similar to mutual funds. It's the same basic idea. You have a whole lot of investors pooling all their monies together, but unlike mutual funds, most exchange traded, there are some technical differences, but one of the big things is that most exchange traded funds are usually index funds. So there's not a lot of buying and selling of things in the portfolio going on. Typically, they'll put together a package of securities that mimics whatever index they're trying to match, and then that's pretty much where it stays. So if they receive dividends from those companies, they have to pass those through, but you're not going to see a whole lot of dividends from buying and selling things. And so one way of sort of heading those off is to maybe reorient some of your portfolio from mutual funds to exchange traded funds because the dividend rate and the realized the capital gains dividends on exchange traded funds tend to be,
The dividend rate on exchange traded funds tends to be a bit lower than mutual funds. So that's one thing that you can do. Another thing that you can do is you can convert those mutual funds to individual securities. And so again, what you're doing is you're curtailing potentially how much buying and selling is going on in the portfolio that you would have to report on your 10 40. So one thing we've talked about before on the podcast is direct indexing. So instead of buying, for example, an s and p 500 index fund, well, we might build a portfolio of individual stocks that mimics the performance of the s and p 500 fund and not buy and sell a whole lot unless we see an opportunity to harvest a tax loss. And so that orientation of looking for losses as opposed to buying and selling stocks for growth, that can save you a bunch of money. And then the ninja way that you can try to avoid realizing capital gains on mutual funds is by getting a projection of what those funds are likely to distribute this year, and if it's going to be significant, if it's going to be more than the profit would be of just selling those. Now you sell the fund before it declares its dividend, before it goes what we call X dividend. And
Speaker 1 (10:17):
How do you know when that's going to be? Do they tell you when that's going to happen?
Speaker 2 (10:20):
Yeah, they usually tell you a bit ahead of time. So anywhere from a couple weeks to a month or so before they declare it. And most of these funds, again, they usually declare right at the end of the year, right in December. So if you start looking around early into mid-November at the mutual funds website, you should be able to see what they project they will distribute this year. And so we've been looking at that now for a couple of weeks. And in certain funds, they're projecting that they're going to be distributing two to 5% of the value of the fund in dividends. Well, if we've got less than a 5% gain in the portfolio, we might want to sell that out and realize a smaller gain for now and just sit it out. We can either move it to a different fund that's not going to be declaring a dividend.
What we'd probably do actually is move it to cash, wait until another fund that we would replace it with has declared its dividend and then buy in after the dividend. So we avoid that year end tax thing. Or you can even just sit on the sidelines and then go back into it. You can sell it before they declared the dividend, and you can buy it back after they declare the dividend. And if you really want to be safe about it, you'd wait 30 days between the sell and the buy and then you can lock in whatever tax effects would be.
Speaker 1 (11:40):
I would assume that that would have to be, it's just a lot of hoops to jump through. It would have to be a considerable hit on your taxes, like a big deal to bother to go all that.
Speaker 2 (11:54):
And it is. So some funds are more prone to that than others. So part of it is just how familiar you are with your funds. So if you have large company, large company, US Stock Fund, or if you have a utilities fund or something like that, chances are the capital gains are not going to be huge. If you've got an aggressive growth fund or if you've got a small company fund, you're likely to see more dividends in those because the price changes of stocks in those portfolio are likely to be bigger and they're swinging for the fences more. And those funds then would be a more conservative kind of larger company fund. So it is a bunch of work to keep track of it, but we do that for clients just because we've got a limited number and it's not a small number, but it's not huge number of things across all of our portfolios. So we can take care of hundreds of clients by looking at two or three dozen funds, and so we know when they're going to be declaring their dividends. We can take a look at it, we can make any adjustments like that. But if you have those in your portfolio, you can do that same thing by looking at the fund's websites.
Speaker 3 (13:05):
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Speaker 1 (14:30):
All right, so avoiding the rude surprise. What's your 30 minute action
Speaker 2 (14:35):
Item? 30 minute action item is when you get to November and you've got mutual funds and a taxable account. Check those websites, see what they're projecting as dividends for that year.
Speaker 1 (14:47):
Okay, well, thanks again for watching and listening to 30 Minute Money of the website is 30 Minute Money. Steve Wershing appears courtesy of Focused Wealth Advisors and you can find him on their website and me at rocvox.com. Thanks again for joining us on 30 Minute Money.