As we near the end of 2022, the S&P 500 is down around 15% on the year, and the other major indexes are also underwater, to one degree or another. Despite that, however, ’tis still the season for taxable dividends and capital gains to show up in your mutual fund account—and on your tax return.
Many publicly-traded companies pay out some portion of their excess earnings to their shareholders, and the aggregate of these dividends are distributed to, and through, the mutual funds that own shares of these companies. Most of the time, the dividends are paid out in late November or early December, and the fund companies are required to pay those cash flows to investors in the fund at least once a year—typically also in late November or early December. Investors can choose to receive the dividends as cash in their accounts, and the share price of the mutual fund drops by same percentage amount as the dividend paid. Or they can establish a dividend reinvestment plan, where the dividend is automatically used to buy new shares of the fund.
Mutual funds are also required to distribute gains if they sell some of their stocks at a profit. If the investment was held for less than a year, the money is taxed as a short-term gain at ordinary income rates; if held for longer than a year, it will be taxed at lower capital gains rates. One of the worst tax traps an investor can encounter is receiving a high capital gains distribution from a fund that actually lost money during the year; it happens if the fund is liquidating some of the stocks that went up in value since purchase, while the rest of the portfolio is declining. In this lose-lose situation, a new investor will be paying taxes on gains that he or she never participated in.
But believe it or not, there’s a silver lining, even in a down year such as we’re currently experiencing. Strategically recognizing losses in your portfolio can actually save you money at tax time. Let’s say you invested $100,000 in a mutual fund two or three years ago, when the market was still headed north. But now your fund is down by 10% or more, worth only about $90,000. Through tax-loss harvesting, you can take that “paper” loss and make it “real” by selling your fund and re-investing the proceeds in a sister fund. Later, when the market recovers and resumes its upward trajectory you’re going to have gains. This becomes especially important when it’s time to rebalance your portfolio and you need to sell assets Without losses to offset them, those gains could mean writing a big check to the IRS. But instead, you can take the loss you realized at the end of 2022 and use it to offset the gains—often meaning a much smaller check to the IRS.
Here’s another benefit of tax-loss harvesting: If in a given year you aren’t able to utilize all your losses, you can carry them forward to offset up to $3,000 of ordinary income or investment gains for a future tax year. And as long as the money is properly reinvested when you take the loss, you don’t miss out on any upside in the market between now and then.
As a fiduciary wealth manager and financial advisor, Empyrion Wealth Management is dedicated to providing guidance that places the client’s best interests foremost, no matter what the markets are doing at a given moment. To learn more, click here to read our recent article, “Making Lemonade: Tax-Loss Harvesting.”
Stay Diversified, Stay YOUR Course!