Tax loss harvesting: Be careful
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Tax loss harvesting is the investing equivalent of making lemonade from lemons. However, be careful, as you could accidentally generate more taxable income if you are unaware of one important item.
Tax Loss Harvesting
We published an article on March 21st of this year explaining all the ins and outs of tax loss harvesting. Please reference that article on this website for the details.
Briefly, tax-loss harvesting is the strategy of selling investments that are trading below your cost basis. This loss is then “harvested” and available to offset future capital gains. You are then allowed to reinvest those proceeds immediately into the market to take advantage of gains should the market rebound. The reinvestment must be placed into an investment not considered substantially identical to the investment sold.
The Catch?
In December of each year, many mutual funds pay out capital gains. These payouts go to whoever owns the mutual fund on the “ex-dividend” date. These capital gains are gains incurred over the entire year. However, if you purchase the fund the day before the ex-dividend date, you will only own the fund for one day, but you will end up with the entire year’s capital gain distribution. For example, if a mutual fund is expected to pay out a capital gain on December 20th and you purchase the fund on December 19th, you will receive the entire capital gain while only owning the fund for one day.
Remember: Capital gain payouts are a return-neutral transaction, meaning if a fund pays out a capital gain of 10%, the remaining investment’s value is reduced by 10%. The investor now has 90% of the original investment plus a 10% capital gain distribution. Why is this not good? The capital gain distribution is taxable to the investor!
Are There Capital Gain Distributions In This Market?
It might seem unlikely that a mutual fund would pay out a capital gain in a year when both the stock and bond markets are down double digits. However, a mutual fund may have sold an investment in 2022 that was purchased many years ago. In that scenario, the fund will most likely have a gain and need to pay it out to investors as a capital gain distribution this year.
In a year of volatility, many funds face selling pressures as investors cash out their mutual fund positions. Mutual fund managers do their best to manage the tax impact, but occasionally, more gains than losses result in a year-end capital gain distribution.
Summary
If you are considering selling a mutual fund right now for tax purposes or buying a mutual fund because the market is down, be careful. Before you do either, go to the company’s website and look for their year-end distribution estimate and the ex-dividend date.
If the mutual fund is not paying a capital gain distribution, you are in the clear to purchase. If a distribution is planned, check the ex-dividend date and wait until that date passes to make your purchase. A quick check can avoid changing a good tax decision into a regretful tax headache.
Ryan Collier, CIMA, is the Director of Investment Management at Bedel Financial Consulting, Inc., a wealth management firm located in Indianapolis. For more information, visit their website at www.BedelFinancial.com or email Ryan at rcollier@bedelfinancial.com.