The taxes you pay on your investment gains are among the biggest drags holding back the growth of your portfolio. Fortunately, many investors in stocks, bonds and other types of assets have almost complete control over when they pay taxes on their hard-won profits. For mutual fund investors, though, the end of the year is always a dangerous time on the tax front, and this year, the risk of a big tax-bill surprise looms larger than ever.
Why Mutual Fund Investors Have to Worry
Most investors benefit from Internal Revenue Service rules on capital gains that give them considerable flexibility on reporting profits on their tax returns. With most stocks and other common investments, you only pay taxes on capital gains when you sell your shares. So for buy-and-hold investors who prefer to own stocks for years and even decades, taxes are rarely an issue, and as long as you're comfortable holding on to your shares, you can defer taxes as long as you want.
With mutual funds, though, taxes are trickier. Even if you hold on to your mutual fund shares, you can still owe capital gains taxes. That's because of a special way the IRS treats mutual funds: When the fund sells some of its holdings at a gain, it has to pass through the taxable income to shareholders in the form of a taxable year-end distribution.
Many investors choose to reinvest those distributions into additional shares of the fund. But even if you never see any cash from a capital gains distribution, the IRS nevertheless treats it as taxable income that you have to include on your return.
Why 2014 Could Be Especially Bad
Until recently, most mutual fund investors didn't have to worry much about capital gains distributions. The reason: Many funds had considerable losses on their books from the market meltdown in 2008, and even as the stock market recovered, funds used those past losses to offset newer gains.
Unfortunately, most of those losses have run out, and now, capital gains distributions are likely to be on the rise. Adding to the potential problem is the recent turbulence in the stock market, which has encouraged some fund managers to sell off winning stocks to lock in gains rather than face the prospect of further losses.
The tax hit investors will see in 2014 could be massive. Fund-research company Morningstar believes that huge gains could get distributed to fund shareholders this year, with analyst Russel Kinnel estimating as much as 16 percent to 17 percent of fund value paid out as taxable gains. For an investor with $10,000 in a fund, a distribution of $1,600 would translate to an additional tax bill of $240 to $320 or more -- without necessarily seeing one penny extra.
What You Can Do
If you already own mutual fund shares in a taxable account, then there isn't a lot you can do to avoid those taxes. In some cases, selling before a distribution can lead to a smaller tax bill. But if you've been invested throughout the rise in the market over the past five years, then it's likely that you'd have just as big a tax hit if you sold out than if you held on and received a year-end capital gains distribution.
What you can do, though, is to avoid putting any new money into your mutual fund until after it pays out its year-end distribution. That way, you'll end up buying shares at a cheaper price and getting more of them, rather than buying fewer, more expensive shares but immediately getting a distribution back to keep or reinvest.
In addition, if you want to use mutual funds, keeping them in individual retirement accounts and other tax-favored accounts can be the best way to avoid tax problems. Within an IRA, 401(k), or other qualifying retirement account, mutual-fund distributions don't result in any extra tax on your tax return.
In the past, lawmakers have considered changing tax laws to allow those who reinvest their distributions in additional shares to defer any capital gains tax liability. So far, though, those efforts have come to nothing, and so mutual fund investors need to keep their eyes on any announcement their fund companies make about year-end distributions and take the appropriate action to minimize what taxes they'll have to pay.
Mutual Fund Investors, Beware: A Scary Tax Bill Is Coming
Is your water bill due quarterly? Figure out how much you need to save each month to have enough to pay for the bill when it comes, and put that amount aside each month so you'll be prepared. Do the same for any bills due regularly but not monthly.
Bills you only have to pay once a year can be even harder to remember, so be sure to note things like property taxes, auto registration fees and insurance premiums and budget for them as well.
Annual subscriptions and memberships regularly trip up people's budgets. Be sure to set aside money each month for things like:
Newspaper and magazine subscriptions.
Warehouse club memberships.
Road service membership fees.
Other expenses don't happen on a regular basis, but you can still predict the need to pay for them over the course of the year. Chief among these are repair and maintenance expenses, with the biggest ones being car-related costs (oil changes, inspections, new brakes or tires, etc.) and home costs (leaky faucets, spring-time yard work, etc.).
Some home repairs go beyond the scope of "routine" and require a significant amount of money in reserve. These can include replacing your roof, installing new windows or doing a major home renovation. You can anticipate the need for most of these repairs before you have to make them, so be sure to start budgeting for them in advance.
You also need to repair and maintain your body, so factor in medical costs like annual physicals, eye exams and dental checkups, as well as co-pays and prescriptions costs if you have any ongoing conditions.
If you plan to purchase any large items in the foreseeable future, from appliances to a new car, make sure you're putting aside enough each month to pay for them in cash. It's always best to pay for big-ticket items upfront rather than finance them (unless you can get a fantastic discount by financing and can pay the balance in full before any interest kicks in).
From birthdays to holidays, there are plenty of special occasions each year to budget for. Make sure to include:
Party hosting costs.
Dinner costs if you take someone out to celebrate.
Wedding expenses (gifts, travel, hotel stays, etc.).
Your four-legged family members also need to be part of your budget. Pet care costs to consider include:
Food and treats.
Vet bills and medications.
Boarding or pet sitting.
Do you take an annual vacation? Travel twice a year to visit family for the holidays? Set aside money each month for any travel-related costs such as airfare, hotels, meals, rental cars and souvenirs.
Whether you run a business or simply a household, there are certain expenses you may need to plan for in the business category. These can include:
Tax preparation fees and tax payments.
Dues for professional organizations.
Whether you give annually to a charity of your choice or like to have some money set aside for your friends' and family's fundraisers, make sure to allocate enough each month to cover these donations
A good budget allows for a little "free" spending money you can do with as you please. It can be $20 a month for fancy coffee at your favorite coffee shop or $100 a month to feed your favorite hobby. The amount doesn't matter so much as the fact that you're allowing yourself a little guilt-free fun to keep your budget from feeling too restrictive.
Depending on your lifestyle, your eating out and entertainment budget could be a little or a lot. Whether you prefer to have dinner out once a weekend or see a movie every few weeks, figure out how much you'd ideally like to have and then examine any budget categories you can tweak to make room for it. If you realize you need to cut back on your habits a little to save money, that's fine too-at least you're aware of it now so you can act accordingly.
Even if you're not a clothes horse, chances are there are certain items you'll need to purchase throughout the year. These can include:
Updated work clothes.
A new coat, hat and other accessories come winter.
A new bathing suit for the summer.
New shoes as yours wear out.
Back-to-school clothes for your kids.
Calculate your annual spending on all clothing and accessories and divide that amount by 12 to determine how much you should be putting aside each month.