The Independent Investor: Beware the Tax Hit From Mutual Funds
Plenty of investors will be faced with an unpleasant surprise. Any day now, one or more of the mutual funds that you own will be sending out their capital gain distributions for the year.
The tax hit could be quite large this year.
Many investors are not aware that mutual fund companies are required to distribute at least 95 percent of their capital gains to investors each year. Given the double-digit gains in the stock market last year, those gains could be an unwelcome liability when tax time rolls around.
At this late date, there is little one can do about it, other than pay the piper, but this year you can take steps to minimize 2018's potential tax liability. Since the tax reform act did not change capital gains taxes, you can expect that short-term capital gains (less than 12 months) will be taxed at the same rate as your income tax bracket. Long-term capital gains, however, will continue to be taxed at 15 percent.
The job of most mutual fund managers is to buy low and sell high. That's what creates track records, which, in turn, attracts investors to their funds. But mutual funds are just like individuals when it comes to capital gains. Anytime a mutual fund sells a security, no matter what the asset, that gain is taxable. And since mutual funds are considered pass-through entities, they are required to pass along to you any of these taxable gains.
In the grand scheme of things, capital gains distributions could be considered a luxury problem since we want the mutual fund we are invested in to turn a profit for us. So producing capital gains (as opposed to capital losses) is a good thing. But some caveats do apply.
Distributions reduce the fund's net asset value, regardless of whether they are long-term, or short-term capital gains, qualified dividends, or a return of capital. The problem might be in the timing of your purchase. If, for example, you purchased such a fund after all the gains were made, but before the distribution, you will be sent the capital gain (plus the taxes you will owe) while the mutual fund you purchased would decline by the amount of the distribution. You would be left with an after-tax loss on that mutual fund investment.
So the morale of this tale is if you are going to stay invested in mutual funds in a non-retirement account you better start tracking the upcoming capital gains distributions on the funds you own or are considering purchasing. In general, most mutual funds pay one or two capital gain distributions each year, normally sometime during the summer, and the last one toward the end of the year (late November or December). Try to avoid buying mutual funds at those times.
The mutual fund industry is aware of how these sudden taxable events impact shareholders. Most managers try to avoid dumping huge gains on investors, especially short-term gains, which are taxed at a higher rate. However, at certain times, they are forced to do just that.
During market declines, for example, when they are faced with unusually large redemption requests, then fund managers may be forced to liquidate positions that they would have preferred to hold, but can't.
Today a shareholder of mutual funds can easily find out when and what upcoming distributions will be made by simply accessing each mutual fund's website. There, you will find a wealth of information concerning distributions. Many fund websites will give you distribution guidance several months before the event. That makes it easier for you to make informed investment decisions.
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The Independent Investor: Confusion Reigns as Taxes Change
At the best of times taxes are confusing, so much so that most people hire an accountant to prepare them. This coming year should be a real doozy for the accountancy industry.
Given the massive changes to the tax code that will go into effect next year, taxpayers are rightly concerned (and confused) on exactly what the rules will be and how they will impact their families.
"Most (although not all) taxpayers would owe less under the new rules, according to analyses by various independent think tanks, including the Tax Foundation and the Tax Policy Center," according to Charles Schwab and Co.
In high tax states, lines are already forming at the local assessor's offices. New York Gov. Cuomo just signed an emergency executive order that urges counties in the state to send 2018 property tax bills now before the end of the year. That way, residents can pay next year's taxes before the end of the year thereby still taking a tax deduction against their federal tax bill.
Money management firms across the country are also being besieged by clients who want to pay next year's fees in advance in an effort to take advantage of that tax deduction before those too expire in 2018 under the new legislation. Phone lines to most accountancy firms ring busy and even office voice mails are full.
Let's start with your tax brackets. There are still seven tax brackets but the new legislation generally lowers rates across income levels. For a couple filing jointly, the new brackets will be 10 percent for taxable income up to $19,050, 12 percent on $19,050 up to $77,400; 22 percent on income up to $165,000; 24 percent up to $315,000; 32 percent to $400,000; 35 percent to $600,000; and 37 percent on income above $600,000.
In addition, since most Americans do not itemize their tax deductions, the standard deduction available to those taxpayers has doubled from $12,000 for individuals and $24,000 for couples. However, what the government giveth, the government can also taketh away. The personal exemptions for individuals were also removed, which comes out to $4,050 per person.
However, overall, if you're a low- or middle-income household, an increased standard deduction combined with an increased child tax credit should lower your tax bill.
The new tax law has placed a cap on itemized state and local tax deductions that have been up to this point fully tax deductible against your federal taxes. The cap on combined state and local taxes amounts will be no more than $10,000. People with heavy tax burdens in high-tax states such as New York, New Jersey, California and Massachusetts will be hurt the most.
And in order to close as many loopholes as possible, the Republican lawmakers barred these taxpayers from prepaying in 2017 any state or local taxes that will be due next year.
Those who have been choosing to itemize deductions may now have to reconsider which is better: a reduced level of itemized deductions versus the standard deduction. Some families may now fare better taking the simpler standard deduction.
The Internal Revenue Service has also warned high-property state taxpayers not to prepay property taxes before the end of the year unless your local government has already assessed your property for 2018. For example, my town has already billed me for next year's taxes, while across the border in New York State, the local authorities bill in the year taxes are due.
Mortgage interest amounts will also be limited to the first $750,000 of a loan for a newly purchased first or second home. Although it is early days, many analysts believe this tax change will have a devastating effect on areas that rely on second homes and their owners for their livelihood. People who might have considered buying a second home will find the new rules will be a disincentive to purchase. It could also make it harder for home owners in those markets to sell their homes. The net effect would be a dampening of economic activity in those areas.
This would impact many lower income families who depend on second home owners for their livelihood. Those who provide landscaping, lawn care, house maintenance and repairs, snow plowing and a myriad of additional services supplied by mostly blue collar workers would feel it the most.
There are countless other areas from healthcare to pass-through income that has been affected by the new rules. In future columns, I will examine many of these changes. But for now, rest assured that as 2018 unfolds, there will be countless variations to this legislation that will continue to impact the economy and all of us in unexpected ways.
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The Independent Investor: To Roll, or Not to Roll Your 401(k)
Rolling your 401(k) or 403(b) into an IRA can be a good idea for some savers but not for others. Here are some things to think about before you make a decision.
In my last column, I outlined some of the more obvious reasons for rolling over your retirement accounts: cost savings, larger selections of investment choices, more flexibility. I also discussed some of the cons against rolling it over: the ability to borrow against your 401(k), a lower age for beginning distributions from your 401(k) (55, versus 59 ½ for an IRA), the ability to delay minimum required distributions after 70 1/2, if you are still working.
This week, I want to focus on one of the greatest weaknesses of just about all employee tax-deferred retirement accounts. When the public and private sector came up with the concept of tax-deferred retirement accounts to replace pension funds, they forgot one extremely important detail. Pension funds for a company's employees were managed by full-time professionals.
That makes sense because managing retirement savings is a full-time job. Unfortunately, the government ignored that fact when they gave the responsibility of managing tax-deferred retirement savings to the worker. Few workers are qualified to do that. They are totally focused on the full-time job of making a living, getting ahead and providing for one's family, as they should be.
Even if they had the education, knowledge and skill to manage money, (which most don't), they have few resources to do that job successfully. And as years of contributions have accumulated, many retirees now have hundreds of thousands of dollars (if not millions) invested in these employee-sponsored plans.
At the same time, the financial markets have changed enormously. It is a world of derivatives, leveraged investments and the commoditization of everything from individual stocks to Bitcoin, the individual investor is increasingly outgunned.
As a result, most 401(k) contributions are funneled into funds that automatically change your exposure to bonds and stocks based on the date you plan to retire. These target date retirement funds tend to be expensive and have a number of unintended consequences. One of which is that the closer you get to retiring, the more bonds are added to your portfolio (since bonds are considered a safer investment). In an environment where interest rates are rising and bond prices are falling, however these "safe" investments are fraught with risk.
In today's constantly-changing, global financial markets, the set-it- and-forget-it approach to investments does not work very well, just witness the debacle in losses back in 2008-2009 to most savers' 401(k) assets.
By rolling over your 401(k) to an IRA, the option of professional money management becomes available. It is one of the reasons that brokers, annuity salesmen and investment advisers are so focused on the area. This "gold rush" by the financial community to manage these assets has led to a myriad of abuses. Unscrupulous brokers, financial planners and advisers have stuffed these rollover accounts with high-priced investments with sub-par returns that have generated big commissions and fees for their firms while stiffing the poor retirees.
Worst of all, countless elderly retirees have been sold annuity products that are not federally-insured or regulated. These restrictive investments are inappropriate for the vast majority of savors. They command some of the highest fees of almost any investment product (as much as 15-20 percent of the entire investment over the lifetime of the annuity contract). What's
worse, if you try to sell them (as many do) they are saddled with huge penalties for years.
Money management, on its own, is no panacea; there are good advisers and bad ones, so you still need to do your due diligence. Make sure that whoever you select is registered, is a fiduciary and, if possible, offers more than just money management. In planning for retirement there are a number of other areas besides money management that are important, everything from financial and estate planning to Medicare, Social Security and elder care issues.
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The Independent Investor: Should You Roll Your 401(k) Into an IRA?
Some retiring workers roll their 401(k) tax-deferred savings account into an Individual Retirement Account (IRA). There are good reasons to do so. But for those who are not retiring, the decision is not so clear cut. Here are some pros and cons to ponder.
In my neighborhood, for example, a local company with more than 300 employees is being acquired by another company from Chicago. As a result, the employees of the acquired company are being offered a choice: they can roll over their existing 401(k) into a new plan offered by the Chicago company, roll their 401(k) into an IRA, or just take the money out, pay taxes and spend it.
Obviously, the last option is the worst choice. The tax bill on such a lump sum would be quite large and if the employee is not yet 55 years old, an additional 10 percent tax penalty would be levied on the money as well. So let's assume that you are a rational human being who can see that option would be financial suicide.
The two most obvious reasons to roll over your money into an IRA is that you suddenly have an entire universe of investment options to choose from instead of the typical 10-20 choices normally listed in a company 401(k) menu. The second reason is that you will have more control over your retirement funds. You may, for example, identify better performing funds with lower costs. If the markets take a tumble, you can step aside, rather than stay invested.
Sometimes, you can also reduce costs, while at the same time improving your performance. Few 401(k)'s offer the option to invest in index based exchange-traded funds (ETFs). Some of those ETFs charge a lot less than some mutual funds. This can be especially important to someone who contributes regularly to their plan over two to three decades. Studies have shown that in the past, total fees and expenses can amount to as much as 33 percent of your total retirement assets over a 25-year period.
However, some large companies with billions of dollars of assets in their employee 401(k)s have access to institutional-class funds that charge lower fees than their retail counterparts. Your choice of investments is still limited, but at least your costs are lower.
But there are other reasons, depending on your circumstances to simply roll over your 401(k) to another one. Some 401(k) plans offer stable-value funds, which are a low-risk option for an extremely conservative investor. These funds provide an attractive alternative to a typical money market fund. And unlike pure bond funds, they won't get decimated if interest rates rise.
Sticking with a 401(k) is also the best option if you plan to retire early. If you roll your money into an IRA and plan to start withdrawing before the age of 59 1/2 years old, you will be charged a 10 percent penalty by the IRS. In a 401(k) plan, workers who leave their jobs in the calendar year they turn 55 or later can take penalty-free withdrawals. In both cases, however, you will still have to pay regular income taxes on your withdrawals. You can also take out a loan against your 401(k) but not from your IRA.
On the other end of the spectrum are guys like me, who don't ever plan to retire. Ordinarily, at age 70 1/2, I would be required to take a required minimum distribution (RMD) from both my IRA and 401(k). If I continue to work past that age, however, not only can I continue to contribute but I am not required to take an RMD from my company 401(k).
In my next column, I will discuss additional positives and negatives as well as some real life examples of those who have opted for one over the other. Clearly, this is a complicated subject that requires analysis and direction. It would be a good idea to seek outside professional advice. If you do so, make sure you ask an adviser who is a registered fiduciary that puts your best interest above herself and her company's.
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The Independent Investor: Will the Lights Go Out?
The deadline looms. There is no deal in sight. Various political factions are jockeying to get their demands met. It is all part of an annual compromise to fund the government for another year.
So what else is new?
If the government does shut down on Saturday morning, it will be the 18th such occurrence in U.S. history. In every case, the nation has survived, although at times the cost has been great. There was, for example, a 16-day shutdown back in 2013 that resulted in a $24 billion hit to economic output and caused 850,000 workers to be laid off.
We all know it costs the American people more to shut down the government than it does to keep it open. In this age of partisan politics, where compromise is a rare commodity, the drama of a government shutdown goes on year after year. At the 11th hour, a series of horse trades normally occurs, allowing both sides to kick the can down the road for a little while longer until the next deadline looms.
You might have thought that with a Republican-controlled House, Senate and presidency, that passing a spending bill would have been smooth sailing. Far from it, readers may recall that in years past, the Republicans have controlled the House, but the threat of closing the government occurred anyway. That's because there are so many splinter groups within the GOP that there is always someone or some faction that insists on more or less spending; usually more on defense and less on everything
In the Senate, although the Republicans hold the majority of seats (52), you still need 60 votes to pass a spending bill. That requires the cooperation of eight Democratic Senators. To get their votes, the Democratic leadership wants legislation passed that would protect "The Dreamers" from deportation. Those 700,000-plus illegal immigrants who were brought to the U.S. as young children and are now caught up in the web of President Trump's animosity towards all immigrants, legal or otherwise.
The Democrats also want to reverse Trump's decision to halt monthly subsidy payments to insurance companies offering health care to low-income people. Those demands fly in the face of ultraright Republicans, many of whom want spending cut (except for defense) in all social programs, especially those involving Obamacare and immigrants.
Thursday, President Trump and Republican congressional leaders were meeting with Chuck Schumer, the Senate's Democratic Leader, and Nancy Pelosi, his counterpart within the House.
The betting is that they will all agree to disagree, but extend the existing spending bill by two weeks.
That would enable the GOP to finish up their tax package before re-focusing on a spending plan.
If so, that would simply kick the can down the road to just before Christmas. Given that only 18 percent of voters would go along with even a temporary shutdown of the government, the hope is that our legislators would be loath to cause a shutdown during the holiday season.
I am not sure I agree with that. The Republicans seem oblivious to voter sentiment. Their tax bill has less than a 30 percent approval rating among Americans, who rightly believe the "tax cuts" benefit the rich and corporations, while savaging most other Americans. Both the president and his party have their own end game, which does not include the majority of voters.
However, even if we do see another shutdown, the impact will be short-lived both for the economy and the markets. Maybe that is what the Republicans are counting on.
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