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Is The Phantom Lurking This Halloween?

41655642_s Folks, with any good retirement system, not only do you need investment and income plans, but you need a sound tax plan as well. You must have strategies that are tax efficient. We all have a right to legally pay less tax, agreed? Heck, if we legally pay less tax then what have we essentially given ourselves? A pay raise.
 
This week, I want to discuss actively managed mutual funds and how to increase tax efficiencies within investment strategies.
 
First, let’s take a high-level view of mutual funds. Mutual funds tend to be popular investment vehicles used in many retirement strategies. Generally, there are three types of mutual fund shares available to retail investors, “A,” “B” and “C” shares. The basic differences between the three involve the timing and amount of commissions and expenses paid for each. “A” shares charge a sales commission up front, which is usually about 4 to 6 percent of your investment, in return for a lower yearly expense ratio. “B” shares charge a deferred sales commission and usually have a higher expense ratio, and “C” shares will generally have little to no commission charged up front, but typically have the highest expense ratio of all three retail choices.
 
Investors buy mutual funds because of their perceived flexibility, ease of diversification, and returns that can make them seem attractive. But, as I always warn, you need to dig into the details, specifically the tax ramifications, of any financial vehicle before making a decision to use it in your financial plan.
 
This brings me to a recent class I taught to retirees at Cape Cod Community College. One of the topics we discussed was tax efficient investing. I asked the class, “Who owns mutual funds?” Pretty much the whole class raised their hands. Then I asked, “Who owns mutual funds outside of a 401(k) or IRA?” About a third of the hands dropped. Lastly, I asked them, “Who thinks the mutual funds in your brokerage account are tax efficient?” Surprisingly, half the hands stayed raised.
 
Hmm. The Phantom could be lurking.
 
I proposed the following scenario to the class. Let’s say that we have $500,000 in our taxable brokerage account and we invest it in some very popular “A” share mutual funds. As discussed above, “A” shares charge brokerage commissions up front in exchange for a lower yearly expense ratio. So, right off the top, let’s deduct 5 percent of this, or $25,000, from the value of our account, leaving us with a balance of $475,000.
 
Now, let’s assume that we are at the tail end of our fair market winds, we are heading smack into a down market and the value of our account drops 20 percent. We lose another $95,000. This can happen in the market, right? So for those of you checking the math along with me, that takes us down to the $380,000 mark.
 
So now let’s fast-forward to January of the following year. We make that cold walk to our mailbox and open it to find a letter from our brokerage house. There is a 1099 from each mutual fund that outlines the dividends and capital gains that we must pay income taxes on. How could this be? We are down $120,000; we have market losses of $95,000, and we have to pay capital gains taxes to Uncle Sam? Let me introduce you to the “Phantom”—Phantom Income Tax. It happens, and it’s just one of the many tax inefficiencies of actively managed mutual funds.
 
But let’s say the funds haven’t lost 20 percent. Then, aren’t they great investment vehicles? Not so fast.
 
According to the Investment Company Institute just over 30 percent of mutual fund assets are held by individuals in these taxable accounts, rather than 401(k)s and IRAs. By law, every year, mutual funds must pay out to investors nearly all their income, which includes interest, dividends and net realized capital gains—in short, the profits on their trades minus any offsetting losses.
 
The payout for these mutual funds has boomed in recent years, from $37 billion in capital gains in 2012 to over $130 billion in 2014, as the markets rose. In 2014, investors had to pay Uncle Sam his due—even if they were new investors who didn’t get the benefit of their assets appreciating before they were sold.
The payouts for most mutual funds have yet to be announced for 2015. I explained to the class that while there may have another surge of payouts, the Phantom may be lurking thanks to this year’s weaker and more volatile markets. Some funds could actually end up with negative returns, while shareholders are stuck with a tax bill. This can happen if the value of a fund falls and its managers sell appreciated assets to either return money to investors exiting the fund, or because they want to rebalance the portfolio amid market volatility.
 
So, what do you do? How do you maximize tax efficiencies to help mitigate the Phantom? Generally speaking, if you choose to own actively managed mutual funds, then these tax inefficient mutual funds are best held in your tax-deferred accounts such as your IRAs or 401(k)s. More tax efficient vehicles, such as index mutual funds and exchanged traded funds, which typically have lower taxable payouts, and therefore, less of a Phantom impact, should be held in your taxable brokerage accounts.
 
When building your retirement system, remember to build tax efficiencies into your plan. Folks, it is not always what you make but what you keep. This year, don’t let the Phantom “trick” you out of a tax efficient strategy. A little advance planning could give you the “treat” you deserve.
 
Be vigilant and stay alert, because you deserve more. Have a great week.