Like many, you might be awaiting a 1099 form so that you can file your 2017 tax return. In the first months of 2018, we saw equity returns diminish, but the market correction in early February was expected and needed. (See our previous blog to learn more). You may be asking yourself, “what effect will this have when I file my 2017 taxes?” It may affect you more than you might expect due to mutual fund capital gains distributions.
Mutual funds are an efficient way to attain investment expertise in a cost-effective way. For example, an investor gives the mutual fund money to invest as they see fit in the selected mutual fund. A mutual fund holds a collection of diversified investments and the investors benefit from the mutual fund team’s expertise.
In 2017, many equity or stock mutual funds did exceptionally well with the domestic and international equity markets performance. Most mutual funds will have an investment style and may have parameters that allow for maximum percentages in asset classes and individual holdings. These parameters ensure the mutual fund maintains a diversification that appeals to its investors.
For example, XYZ Mutual Fund must adhere to no more than a 5% allocation to any one security or stock. XYZ Mutual Fund started by holding maximum 5% in Amazon stock. With a return of nearly 56% in 2017, Amazon’s value exceeded the 5% limitation of a single security, so XYZ must sell a portion of the investment to get back down to or below the 5% threshold even though it still favored Amazon stock. When they sell the stock, all shareholders are distributed a pro-rated share of the capital gains in the stock, which could be more than the gain in 2017.
In this example, the capital gain will be distributed for tax year 2017, but no cash would disbursed to pay any additional tax. This is what may lead to that “surprise” you may see in your tax return this year. The benefit accrued during the 2017 tax year as the value of the stock increased, thereby incurring taxes on that gain. The investor would not have had to pay the taxes on that gain throughout the prior years because XYZ did not sell the stock until 2017.
If you would like to learn more about this, reach out to one of your AP Wealth Management Advisors.
Gene McManus, CPA, CFP®
AP Wealth Management