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Year-end tax review for clients

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As part of our tax planning coverage, we recently spoke to Greg McBride, senior vice president and chief financial analyst for Bankrate.com, to get his insights into the tax issues surrounding mutual funds.

We had a wide ranging conversation on the pitfalls of buying and selling funds at the wrong time, accidentally overstating profits (and consequently, overpaying on taxes), the hidden taxes of inflation-protected bonds and more.

Here is an edited version of that discussion.

Bank Investment Consultant: What are the biggest tax concerns of mutual fund taxes?
Greg McBride: There are two main dividing lines to keep in mind: one between short-term and long-term capital gains. And another between taxable accounts and tax -advantaged accounts, which has implications for which investments you hold where.

As for the timelines, if you haven’t held an investment for more than a year and you sell it, you’ll pay taxes that are the same rate as your income tax. So for higher-income household that can significant. If someone is in the upper tax brackets and they're paying up to 39% income tax, the difference is between paying that [on your investment profit] versus paying 15% or 20% [if they had waited for a year and paid the long-term capital gains rate], and that can be significant

BIC: On the issue of taxable vs. tax-advantaged accounts, which type of investments should be kept in tax exempt accounts.
GM: Munis are an obvious choice. They traditionally pay lower yields because they’re tax exempt. So if you hold that in a tax-advantage account, you have the lower-yielding investment getting tax protection it doesn't need, as opposed to a higher-yielding investment that could better use the tax benefit.

Also, inflation protected bonds are best used in a tax advantaged account because you can end up with a tax liability on phantom income otherwise.

Inflation-protected bonds are best used in a tax-advantaged account because that inflation hedge produces "phantom income," which is taxed.

BIC: Can you elaborate on that?
GM: When they make the inflation adjustment, they essentially adjust the price of the bond. You don’t get that [increased value] until the bond matures, but you have to pay taxes on it each year. In other words, the price of an inflation protected bond is increased each year based on some index like the CPI. Say you buy a bond at $100, and it gets a 3% adjustment. The price increases to $103, and that 3% is taxable even though you don't actually get that $3 in hand until bond matures, or it's sold.

REITs are another investment type that should be held in tax-advantaged accounts because they have high levels of distributions. And tax accounting [on REITs] is quite complicated, it’s not as simple as just interest or dividends. Some of what they pay out is a return of capital, they’re an accounting nightmare.

BIC: How can investors ensure they don't fall into the trap of overpaying on taxes?
GM: It' possible to understate costs, and thereby overstate taxable profits. This is especially true for dividend accounts and funds that have a lot of distributions. But if you’re investing in mutual funds, as opposed to individual securities, the mutual fund company should track that for you. Or if you hold your investments in a brokerage house, they will as well.

The problem is if you switch providers, and move the assets from one firm to another. You may lose some of that tracking of your original cost basis. A lot of that information is passed through when you transfer the assets, so in all likelihood, the number you see as your cost basis is, in fact, accurate. But there will be an asterisk next to it that's basically your new investment firm is disclaiming accountability for tracking the cost basis before the assets were under their roof.

BIC: What about the possibility of buying at the wrong time and paying unnecessary taxes?
GM: That's called 'buying the distribution.' Toward the end of the year, if you’re going to make a mutual fund purchase, you have to be careful of when that year-end distribution is going to be made. You don’t want to buy before that date.

If you buy right before that distribution date, you’re treated the same as someone who bought at the beginning of the year and has actually benefited from all the gains….. Plus, remember, if you buy a share at $1,000 one day and you get a $50 dividend the next day, that $50 is now taxable. And keep in mind, the share price of that fund is no longer $1,000, it’s now $950. So from your original investment of $1,000, $50 came back you as taxable income. That's especially relevant when there's a lot of turnover in a fund, so you need to be cognizant of this with an actively managed funds, but not such an issue with an index fund because there’s lower turnover.…As you get into the fourth quarter you have to be very aware of what you buy and when you buy it.

Clients generally don't want to buy right before the distribution date....As you get into the fourth quarter you have to be very aware of what you buy and when you buy it.

BIC: Any other last-minute tax advice?
GM: Well, I may sound like Captain Obvious, but I'd be remiss if I didn't mention tax-loss harvesting, which allows you to sell investments that had a loss, and deduct that loss to either offset other capital gains you had, or offset up to $3,000 in income. Also you can pair your capital gains and losses. Let’s say you had a big capital gain earlier in the year, now you have the latitude to sell something that has a capital loss of an equal amount, they offset each other and it doesn’t result in any extra tax liability.

Also, as we near the end of the year, people should be aware that there’s still time to put some money in your 401k or IRA that will reduce your tax obligations.

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