The Mutual Fund Tax Trap

Posted on June 15th, 2010 in Investments, Newsletter Articles, Taxes by wayne

In previous articles we have considered the advantages of using indexed Exchange Traded Funds (ETFs) instead of actively managed mutual funds in your portfolio.  In 2010 you may discover another risk associated with owning actively managed mutual funds in your taxable accounts.

If the stock market continues its current sideways to negative movement, by the end of 2010, many equity mutual funds will have less value in December than they did in January.  Even if your actively managed mutual funds lose value in 2010, it is likely that you will owe taxes on these funds when you file your 2010 taxes.  Here’s why:

Before the end of each calendar year, mutual fund companies are required by law to distribute of all of the income and dividends that they received.  With the large stock market gains in the second half of 2009 and early 2010, most actively managed mutual funds will have taken profits in 2010 by selling stocks that have significantly appreciated since they bought them in 2009.  These sales have produced “realized capital gains” for the mutual fund.   If the stock was held less than one year, the gain will be a short term capital gain, treated as ordinary income to the mutual fund owner.  If your mutual fund has a high turnover rate, most of the realized gains will likely be short term capital gains.

If you own actively managed mutual funds in a taxable account, near the end of 2010 the mutual fund will make a distribution that will include all of these taxable gains.  You will be required to pay taxes on these gains, even if the fund has decreased in value since you bought it.  You may also be subject to a significant amount of short term capital gains, even if you have owned the mutual fund for over a year.

Due to the large recent gains in the stock market, many actively managed mutual funds will pay large distributions to the fund owners by the end of 2010. One way to avoid paying taxes on this distribution is to sell the mutual fund before the fund’s distribution date.

Many mutual funds already have large realized capital gains for 2010.  It is wise to avoid buying these funds in a taxable account between now and year end.  If you buy these funds between now and year end, you will pay taxes for 2010 on investments that may have been sold before you even bought the mutual fund.

There are two types of mutual funds that are safer to buy between now and the end of 2010.   The first type of fund is an indexed mutual fund, which is tied to stock market indexes, such as the S&P 500.  These mutual funds typically don’t “turn over” their stocks except when changes are made to the index that they track or when they have a significant number of people selling the mutual fund .  The other type of “safe” actively managed mutual fund is a tax-advantaged mutual fund.  The managers of tax-advantaged mutual funds carefully watch their buys and their sells to minimize the funds realized capital gains.  This approach helps to minimize the annual taxable distributions from these funds.

If you are unsure of whether your actively managed mutual fund is tax-advantaged, you may call the mutual fund company before their published distribution date to determine the approximate amount of their capital gain distribution, as well as the percentages of the distribution that will be short-term and long-term capital gains.

Actively managed equity mutual funds can be a good investment if the manager has the capability of consistently beating his target index.  However, not only must you consider operating fees, 12-b1 fess and other fees associated with mutual funds, for funds held in taxable accounts, it is important to discover the tax consequences of short and long term capital gain distributions associated with the mutual funds that you own or are considering purchasing.

Managing Portfolio Risk

Posted on June 15th, 2010 in Investments, Newsletter Articles, Risk Management by wayne

If you are a business owner or work for a public corporation, a significant amount of your net worth may be in the form of your ownership in the company for whom you work.  You may be taking on significantly more investment risk than you have intended.  Let’s look at some ways to minimize the risk associated with this company ownership.

If a significant amount of your family’s net worth is the value of the company that you own or stocks and stock options in a public company for whom you work, it is important to include these values in the equity portion of your investment portfolios asset allocation.  Often, business owners and corporate executives do not remember that the value of their ownership in the company for whom they work is also an equity investment.

As we have often stated, portfolio asset allocation, in which you determine the percentage of total assets to be allocated between stocks, bonds, alternatives, and cash is a critical activity required to maximize your investment returns.  To properly allocate one’s assets, the value of your ownership in the company for whom you work must also be included with the equity portion of your portfolio allocation.

As an example, let’s assume that you are a fairly aggressive investor with a desired portfolio allocation of eighty percent equities and twenty percent fixed-income and cash investments.  Let’s further assume that your current net worth is one million dollars with $500,000 being in the value in your business and $500,000 in an investment portfolio.  In this example, you should have no more than $300,000 of your investable portfolio in equity investments, since you already have $500,000 of your portfolio invested in the equity (stock) value of your small business.

If you are a more “conservative” investor, and wish to have a sixty percent equities and forty percent in fixed-income and cash positions, only $100,000 of your $500,000 investable portfolio should be put into stocks.  While this is only 20% of your investment portfolio, when combined with your company ownership, your total equity investment is 60%.

It is also important to consider size and the market space of the company for whom you work.  A well diversified portfolio has equities in Small Cap, Mid Cap, and Large Cap companies.  If you own a small company, the equity purchases in your investment portfolio should be in Large Caps and Mid Cap firms.  However, if you work for a large corporation and have a significant amount of your net worth in that company’s stock and/or stock options, your investible portfolio should have a larger percentage of equity holdings in Small Cap and Mid Cap firms.

If your company ownership is in the high-tech industry, focus your investment portfolio on stocks of companies that are in other industries.  This approach helps maintain a well-diversified portfolio, one that is not overly dominated by any industry.   Having exposure to multiple industries helps to minimize the risk that all of your stocks will decline together, since companies in the same industry often have declining stock prices at the same time.

If you work for a publicly traded company, it is important to remember that both the stock that you own and your paycheck are dependent upon the continuing success of your firm.   With so much at stake with one company, it is usually best to have no more than 10% of your liquid net worth invested in the stock of the company for whom you work.

Risk diversification is an important aspect of safely accumulating the resources required for an abundant retirement.  Often, small business owner’s and senior executives forget that the value of their ownership in the company for whom they work is an equity investment that should be included in their investment portfolio.  By honoring this important fact, your total portfolio will be better diversified.

For many years it has been well understood that a well diversified portfolio is critical to an investor’s long term success.  By including your ownership in the company for whom you work in your equity allocation, you will lower your long-term investment risk and help assure your pathway to an abundant retirement .