Welcome to the December edition of FAQs and RAQs!
Here we answer client questions, some asked Frequently, and others asked Rarely.
FAQ: Why do mutual funds pay capital gains distributions, and how can I minimize the tax impact?
Nobody likes an unexpected tax bill, but that’s what mutual funds can serve up when they distribute capital gains. The distributions occur when a fund sells securities at a gain and the tax bill is passed along to shareholders.
Capital gains distributions shouldn’t be a complete surprise: making money and paying taxes go hand in hand. But as legendary investor Warren Buffett pointed out in his 1989 letter to shareholders, annual taxes on capital gains can impede the growth of your portfolio:
Here are two strategies for reducing the impact of mutual fund capital gains:
- Invest in ETFs in Taxable Accounts: ETFs usually have lower capital gains distributions compared to mutual funds, making them a tax-efficient choice.
- Opt for Cash Distributions: Instead of reinvesting capital gains back into the fund, consider receiving them in cash. You can then invest this cash into more tax-efficient vehicles, like ETFs, reducing your overall tax liability.
RAQ: Why are ETFs more tax-efficient than mutual funds?
ETFs offer tax advantages, but not necessarily because they are typically index funds. In fact, a prominent stock index mutual fund is expected to pay a large capital gain distribution this year after shareholder redemptions forced it to sell appreciated securities.
Instead, the ETF tax advantage stems from their design. Unlike mutual funds, ETF shares can be traded between investors without triggering the sale of underlying securities. This feature makes even actively managed ETFs relatively tax-efficient with smaller capital gains distributions.
RAQ: What is the De Minimis rule and how can it disadvantage (or help) municipal bond investors?
Municipal bonds are sought out for their tax-free income, but there's a catch that investors need to be aware of: not all municipal bond interest is exempt from taxes. This is especially true if the IRS thinks you’re getting too good a deal at the time of purchase.
This situation arises with the de minimis rule. If you purchase bonds at a significantly lower price than their face value – falling below the de minimis threshold – you might find yourself taxed at your ordinary income rate on the bond's appreciation.
There’s a silver lining, however. De minimis bonds are often so spurned by investors that they may trade at exceptionally low prices, making their after-tax returns compelling. Furthermore, if interest rates fall, the price of a de minimis bond can increase rapidly as it rises back above the de minimis threshold.
It’s a unique opportunity for investors who are willing to sift through the vast municipal bond market and crunch the tax numbers. In particular, if a de minimis bond matures in the distant future and you expect to be in a low tax bracket, these bonds may make sense.
Have a question? Drop us a line at carlsongroup@rwbaird.com. We'd love to hear from you!
All investments carry a level of risk, including loss of principal. Fixed income is generally considered to be a more conservative investment than stocks, but bonds and other fixed income investments still carry a variety of risks such as interest rate risk, credit risk, inflation risk and liquidity risk. In a rising interest rate environment, the value of fixed income securities generally declines and conversely, in a falling interest rate environment, the value of fixed income securities generally increases. High-yield securities may be subject to heightened market, interest rate or credit risk and should not be purchased solely because of the stated yield. Municipal securities investments are not appropriate for all investors, especially those taxed at lower rates.