Most of us who write about retirement planning and investing all focus on getting in as soon as possible and staying invested as long as you can. I lean towards staying in equities as long as possible; while some advocate a gradual shift as you get older to a more conservative investment portfolio in an effort to protect what you have gained.
And while I also like the idea of wealth preservation, it should be done not with your initial investments in the stock market but with an increase in overall contributions. In other words, as you grow older, add more conservative offerings to the mix rather than shifting current equity exposure.
Lump Sum Investing
Generally though, we often offer this advice on retirement accounts. But what if you have maxed out your 401(k), contributed as much as possible to your Roth and still have money to invest? What if you have decided to get into the markets now with a large sum of money (401(k) plans use a defined contribution model: invest each paycheck, a specific amount or percentage; tax-deferred), be it from a bonus or unexpected windfall?
Mutual funds offer the average investor the opportunity to do three things: spread the investment over a vast number of stocks - or at least more than you might be able to buy individually, use the expertise of the fund manager to ferret out the best investments and to do so without costing too much.
Mutual Fund Pitfalls
We all know that mutual funds have their faults. Some drift in style exposing us to the possibility that we will hold too much of the same underlying investment. Some simply charge too much compared to their peer group. And others simply cannot find the right investments to boost their performance and keep the investors they already have, interested in staying for the long-term.
Attracting new investors and keeping legacy shareholders happy is the real key to the success of the mutual fund. You do not have to be represented by a large mutual fund company to be a very good mutual fund. Not only does the availability of invest-able funds grow, making growth opportunities increase, but the potential for the worst possible problem for a fund, redemptions, stay at a minimum.
Redemptions cause two things to happen. First, the fund manager is forced to sell some of the fund's underlying holdings to satisfy your fellow shareholder's exit. A lot of these types of transactions makes the fund vulnerable and adds to the grief experienced by fund shareholder who believe that the fund is a good one, even if the markets as a whole are suffering.
The second thing it does is force a taxable event. Whether you defer the taxes in your 401(k) or hold the mutual fund outside in a taxable account, this is perhaps one of the worst things that can happen to a future or current shareholder.
Mutual Funds and Taxes
Taxable events are unavoidable in any investment. In fact, it acts as a confirmation that you have made money - in most instances. But in a mutual fund, the tax event might come as a surprise even if the fund will or has posted a loss.
You can be taxed for a capital gain even if your mutual fund has lost money. The fund manager may have been forced to sell long-held and profitable investments in order to keep the share price higher and the returns better in difficult markets. Often, the shares held in the fund pay dividends and these are also taxed. In a taxable fund, this can happen at scheduled times of the year. But no matter when, taxes will need to be paid even if you reinvest the gains (and eventually they will be paid when you take a distribution).
So what can you do? As I said, in a 401(k), there isn't much you can do and it probably shouldn't even be very high up on the list of considerations. But if you are buying a fund that is taxable, it will pay to do a little bit of homework.
Doing Your Homework
Find out from the fund if they are about to make a capital distribution. These often come at scheduled times of the year and it can vary from fund to fund. And it come whether the fund has had a loss or not. Lump sum investors are better off waiting until after the distribution to make the investment.
Avoiding this can be difficult if you have been in the fund for a while. It might be a good idea to sell the fund before this event and move the money into a similar ETF that represents the same type of investment exposure. This avoids a wash sale, a taxable event in itself that increases the owed taxes (from capital gains rate to ordinary income rate) if you buy the same investment within thirty days of the sale.
Reinvested gains change what tax people like to call the cost basis (important when calculating the actual share price against the selling price) of the cumulative total. This doesn't lessen the chances for taxes but does decrease them somewhat.
Keep in mind, this isn't a tax avoidance strategy so much as it is a method to avoid paying for taxes on events that occurred before you invested. Selling the fund and buying an ETF, even in the short-term can create taxes as well if the fund did well. Selling the ETF and moving the money back into the fund can also create a tax situation.
Another thing to consider: move the fund to a much more conservative investment in the same fund family for a brief time (until after the distribution) and then move it back to the original investment. In many instances this is done without any costs at all to the investor. If you don't move in a timely fashion, you will be forced to pay the taxes on the sale.
According to Fairmark, "If you move money from one fund to another within the same family of funds, you're selling one fund and buying the other. If the first fund went up before you made the move, you have to report a gain and pay tax on it. Consider the tax consequences before moving money to a different fund, even within the same family of funds!"
Paul Petillo is the Managing Editor of BlueCollarDollar.com and a fellow Boomer.