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If you’re still recovering from the tax sting of larger-than-expected mutual fund payments in 2021, it’s never too early to prepare for future distributions, according to financial experts.
Mid-year capital gains aren’t common, especially in a bear market year, said Russell Kennell, Morningstar’s principals research director. “And it should be a very light end to this year, save for a huge rally.”
But investors still need to be proactive going forward because “90% of what you can do is in the portfolio building stage,” Kennell said.
A 401(k) plan or individual retirement account can protect you from annual income tax, such as dividends or capital gains. But your brokerage account is taxable, which means you may have to pay an annual business fee.
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“I definitely take that into account when designing portfolios for clients,” said JoAnn May, certified financial planner and CPA at Forest Asset Management in Berwyn, Illinois. “I always keep asset taxes in mind when strategizing where things will go.”
May said that if you have three types of accounts — brokerage, deferred and tax-exempt — it’s easier to choose the best location for each asset.
Since bonds may have lower growth but distribute income, they may be suitable for tax-deferred accounts, such as your 401(k) plan, she said, and investments that are likely to increase in value may be ideal for tax-exempt accounts, such as a Roth IRA. . .
However, if you don’t have the three account options, there may be other opportunities for tax efficiency, May said.
For example, if you have a large enough bond portfolio, you may need to put some assets into a brokerage account. But depending on your income, you might consider municipal bonds, she suggested, which generally avoid federal fees and possibly state and local interest taxes.
Other assets to avoid in a brokerage account are real estate investment trusts, or REITs, which must distribute 90% of taxable income to shareholders, said Mike Piper, a certified public accountant at the firm on his behalf in St. Louis.
“If you must have [funds] In taxable accounts, you want to make sure that it’s generally something with a low turnover.”
Exchange-traded funds or index funds generally generate less income than actively managed mutual funds, which usually pay out at the end of the year.
Another investment best suited for deferred or tax-exempt accounts is an all-in-one fund, which attempts to build a comprehensive portfolio, such as a target date fund, which is an age-based retirement asset.
Because all-in-one funds contain different types of assets, certain parts, such as income-producing bonds, can’t be put into a more tax-efficient location, Piper said.
These investments also limit your ability to use tax losses or sell losing assets to offset gains, he said, because you can’t change the underlying holdings.
For example, suppose your all-in-one fund contains US stocks, international stocks, and bond funds. If there is a drop in the national stock, you cannot reap those losses by selling only that portion, whereas you can have that option if you own each individual fund.
You may also see an increase in the turnover of the underlying funds, resulting in capital gains that can be taxed at normal income rates, depending on how long they are held.
“It’s really not suitable for taxable accounts,” Piper added.