Lessons in Equity Management: Capital Gains Distribution
For our 2006 tax return we had a CPA file our taxes. First out of laziness and second out of some apprehension on my part of making a mistake with the calculations. Since the CPA filed the taxes, I took a cursory look at the finalized return but didn’t dive into it.
This year, I decided to do my taxes on my own before we have a professional file them. I was hoping to develop a better grasp of the tax implications of my financial decisions while we are still in a learning phase. After this weekend, I’m glad I did.
This weekend I learned the importance of paying attention to the tax implications of your various accounts. I learned this that my wife’s “IRA” account will present us with a capital gains distribution of over $3000. What? Why are we being hit with capital gains? Shouldn’t they be rolled over into the account until retirement? Well, with a quick check, I learned that this account is not a tax-sheltered IRA like the one I opened last year.
This money was post-tax money that should have likely been placed in Roth IRA or the like. Currently it is just a fancy, very volatile savings account. Since it is not a tax sheltered account, we are responsible on paying taxes on the capital gains distribution. The irony of this is that these will likely be “paper gains” if the market continues its jittery fall this spring.
I found a good Morningstar article that does a better job explaining the reasons behind this but here is what I learned that we need to consider doing:
1. We need to consider switching this money to tax-managed funds Apparently these funds make an effort to realize some losses on holdings when they have to realize gains on others. With this tax consideration, these funds can come out ahead.
2. We need to consider switching to EFTs for this account. They apparently don’t have as many strategies available as the tax-managed funds but are a good second choice.
3. When switching out we need to be aware of funds that have had large returns over the past 3 years. These funds will have a huge tax bill regardless of whether we make any money or not because capital gains are based on gains that the fund realized and distributed to all shareholders equally regardless of their cost basis.
So if I go running to emerging markets right now, I could buy close to the top AND get hit with a large tax bill. Note to self, don’t do this.
