Tax Tactics for Fund Investors

12/24/2020 5:00 am EST

Focus: FUNDS

John Bonnanzio

Editor, Fidelity Monitor & Insight

If football and baseball are America's two favorite national pastimes, tax mitigation must certainly be a close third! Unlike sports, of course, lowering one's tax bill has tangible personal consequences, asserts John Bonnanzio, contributing editor to Fidelity Monitor & Insight Report.

And, as someone quite famous likes to say, not paying taxes "makes me smart." We won't go down that road. But we will say this: If there's anything good about having to pay taxes on a fund's year-end distribution, it's that you likely benefited financially from owning the fund in the first place.

Because so many stock and bond funds have multi-year, unrealized gains, the potential for large distributions this year is real. It's also worth mentioning that paying taxes on long-term gains this year may not be as bad as paying them next year as there's at least some chance that that capital gains rates could be headed higher.

While Fidelity's managers have an array of tools at their disposal to help mitigate short- and long-term gains (including offsetting losing positions with winners), eventually, Uncle Sam will come a-knockin'!

To that point, while the average Fidelity fund is up only 2% this year, more than 50 have double digit gains ranging from 10% to more than 40%!

And for large-cap growth funds, their average 3-year total return was over 70%. So if your fund hasn't already had significant year-end distributions, 2020's realized gains may be significant.

Keeping in mind that a fund's capital gains distributions are only a concern in non-retirement accounts, there are some year-end maneuvers you might execute with the counsel of your tax planner, accountant or advisor.

At the very least, if you're holding funds that have appreciated significantly, and/or have high turnover rates or that experienced significant withdrawals earlier this year, then such funds are more likely to deliver significant year-end distributions. (Capital gain distributions include share price appreciation, dividends and interest.) Even with tax season around the corner, there is still time for you to be smart.

Tax Tactics

. Don't buy a fund just before a distribution. This advice is a lay-up: you can never make money buying a fund's distribution - you'll only wind up with a tax bill and none of the upside for having owned the fund.

Why? Whatever the distribution amount, the fund's NAV declines by an equal amount. No upside gains, just a tax bill. (See box below on how far "in front" of the distribution you need to be.)

. The best defense, is a good offense. Or is it? Some investors facing a large year-end capital gains distribution may decide to sell their shares pre-emptively.

While you can't be prohibited from selling shares, anything sold at a loss and repurchased within 30 days is considered a wash sale, which means the IRS will disallow the loss. And if your shares have appreciated in value, you're not completely out of the woods as you'll still pay taxes on those gains.

. The right fund for the right account. Tax rates on long-term capital gains are typically lower than those on ordinary income.

Some investors exploit that difference by putting their income-generating bond funds into tax-deferred retirement accounts, whereas stock funds (especially those that throw off little income) are put in taxable accounts.

. Know your fund's cost basis.

This information is readily available on Fidelity's website. That figure is important because if you've been reinvesting dividends and capital gains, you may find that your cost basis is closer than you think to the current value of your shares.

If so, your tax obligation may be more manageable (smaller) than you had thought. While still other strategies for reducing taxes risk putting the proverbial tax cart in front of the investment horse, here are some other worthy ideas:

. Consider buying a diversified, low-turnover stock fund. Index funds like Total Market and Zero Total Market typically have very low turnovers of around 2%.

But a word of caution: With changes made to a variety of S&P Dow Jones indices in July (Apple's stock split significantly reduced its weight in the Dow Jones Industrial Average but not the S&P 500), increased turnover sometimes fuels realized gains.

. Consider municipal funds. Covid-19 and the ensuing decline in government tax receipts (especially from revenue bonds) is an unresolved and unprecedented problem for this asset class.

Nonetheless, highly taxed individuals following our Income Model in a taxable account should still consider holding Conservative Income Muni fund or even a muni money market fund rather than its higher-yielding, taxable counterpart Conservative Income Bond.

. Talk to your tax planner about variable annuities.

They're not our preferred investment vehicles (we don't like their fees and paucity of investment options), but we'll concede that for investors who have maximized all other options, these tax-deferred insurance products may have some merit.

Of course, there are other tax-strategies to consider, including holding funds for more than a year (triggering a long-term gain but at a lower rate than short-term cap gains), offsetting capital gains with losses (there's an annual limit of $3,000), and selling higher-priced fund shares first.

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Tax Tactics for Fund Investors
12/24/2020 5:00 am EST

If football and baseball are America’s two favorite national pastimes, tax mitigation must cer...