One of the not-so-festive traditions that I’ve written about in past years is portfolio maintenance and some best practices that investors should consider before flipping the calendar to January. It’s not exactly the most interesting holiday party conversation, but there are some portfolio considerations that Scrooge and other investors might appreciate by the time tax day rolls around next April.
The first tip is avoiding unnecessary mutual fund capital gains distributions. Mutual funds are required by law to distribute all of their short-term and long-term taxable gains that were incurred during the year. Most mutual funds do this in the November/December timeframe to all shareholders of record. It doesn’t matter if you’ve been invested in a particular mutual fund for 10 years or just one day; all shareholders on the “record date” are subject to whatever capital gains distributions are being made in a particular year.
It makes logical sense that investors would want to avoid purchasing a mutual fund right before it is making a capital gains distribution, but how do they know if and when one is occurring? You can visit each fund company website for all of the necessary details of the taxable distribution, or you can go to websites like www.morningstar.com or www.capgainsvalet.com to obtain this information.
An important item to note when thinking about mutual fund capital gains distributions is the investor's unrealized gain or loss in the underlying holding. If I hold a position in my taxable account that has an unrealized loss, then I will generally sell that position before the fund distributes a capital gain. I get the benefit of realizing the loss for tax purposes and I avoid the capital gain. A win-win!
If the same position has an unrealized gain, however, the decision is not so clear cut. If the gain in my position exceeds, or is even close to, the amount of the capital gains distribution, then I typically will not sell the holding. This is especially true if my holding period is short term (i.e., less than one year) and the mutual fund is paying a long-term distribution.
While I am on the subject of realizing losses for tax purposes, I think that investors might be particularly surprised when looking at their portfolios right now. Yes, the S&P 500 is up more than 20 percent so far this year, but by no means has a rising tide lifted all boats in 2021. As of this writing, more than 100 stocks in the S&P 500 have a negative return so far this year, as do several ETFs that have become extremely popular among investors as of late.
When I have been presented with these “opportunities” to harvest losses in prior years, I have found that a sensible strategy has been to purchase an equivalent security with the proceeds from the sale. In doing so, I was able to realize the benefit of the loss for tax purposes while maintaining exposure to market/asset class due to my purchase of the equivalent security. The only caution to note with this strategy is to not buy a security that is “substantially similar” to one that was sold. Doing so would trigger a wash-sale violation, and the loss would not be allowed for tax purposes.
Before we close out 2021, be sure to take one last look at your portfolio to see if there are some money-saving changes that can be made. Nobody will fault you for channeling just a little bit of Scrooge this holiday season.
Commonwealth Financial Network® does not provide legal or tax advice. You should consult a legal or tax professional regarding your individual situation.