I don’t know about you, but for me, paying taxes feels like a giant slap in the face.
I’m minding my own business, feeling good about what I earned during the year, and then all of a sudden, out of nowhere, SLAP! It physically hurts.
So I try to do everything I can to minimize the amount of taxes I have to pay on my investments.
From talking with my friends and family, it strikes me that most people aren’t aware of two ways they can minimize their tax bills. Two insider tips: one for today (capital gains) and one for tomorrow (tax loss harvesting).
Minimize your capital gains
Most investors are familiar with the idea that they’re taxed on what they earn: If you buy a stock and sell it at a higher price, the difference is usually subject to a capital gains tax.
But what surprises a lot of people is that it’s possible to owe capital gains taxes even if you didn’t sell your fund at a gain during the year. Why? Because mutual funds and ETFs also buy and sell securities during the year, so they can incur gains, too. Funds are required to pass those gains on to you by December 31 every year. (See here for the mechanics from the fund’s perspective.)
Free money in the mail? Sounds like a great deal, right? Wrong.
Capital gains distributions are taxable, so you could have a hefty bill to pay. On a $10,000 capital gain distribution, you could owe anywhere from $1,500 to $4,300 in taxes based on your tax bracket and how long the fund held those stocks or bonds. And if your fund distributes a capital gain, you pay taxes on it no matter how well the fund performed that year. Ouch. Not something I was planning on, thankyouverymuch.
Long term, the distributions that lead to these taxes can be minimized. Not all investments pay capital gains distributions, and some funds are more tax efficient than others. ETFs are often considered the poster child for this (you can read more on why here).
But back to the issue at hand. What can you do about this now?
Check out your portfolio to see where you might be hit with a capital gain distribution.
Fund companies generally post gains distributions on their websites in November. My advice – first check your US small-, mid-, and large-cap stock funds. Based on BlackRock estimates, those are the most frequent offenders this year. Trust me, it will be worth it. In total, funds are estimated to pay out almost $173 billion in capital gains. Assuming the highest tax bracket, that’s almost $46 billion going back to Uncle Sam.
Take action before mid-December.
If you find your fund is about to pay a capital gain, you can consider getting out before the gain is paid. If you’re considering a new investment, make sure you don’t invest in a fund that’s about to pay a distribution—your investment returns would take an immediate hit from the tax cost alone. Most fund companies pay distributions before the middle of December, so now is the perfect time to take a look. All in all, consider discussing your options with a tax advisor, to employ the best strategy for you and your portfolio.
Next week on the blog – another underutilized tax tool – tax loss harvesting.
Jessie Syzmanski writes about personal finance for iShares. You can find more of her posts here.
All regulated investment companies are obliged to distribute portfolio gains to shareholders at year’s end. Trading shares of the iShares Funds will also generate tax consequences and transaction expenses. This material is not intended to be tax advice. The tax consequences of capital gains distributions may vary by individual taxpayer. Please consult your tax professional or financial adviser for more information with regard to your specific situation.