“Money, it’s a crime. Share it fairly but don’t take a slice of my pie.” -Pink Floyd, Money
Unless you have some type of tax-sheltering structure in place (or tax losses that can help offset income or gains), then Uncle Sam will almost always be taking a slice of your “pie” (aka investment distributions). The way in which investments are taxed varies significantly, but how does that work, exactly? Also, where do fees fit into the equation, and – to finally discuss the question that prompted this series over a month ago – why are investment returns often confusing? Read on for the answers.
Taxes!
Taxes always deserve an exclamation point simply because they’re exciting! Show me someone who isn’t excited about taxes, and… Okay, maybe they aren’t exciting, but they ARE important to be aware of. For this discussion, we’ll assume our investments are in a standard taxable account, where the underlying investment determines the tax implications. That’s unlike a qualified account, where the tax impact is a function of the tax wrapper: e.g., Traditional IRAs/401(k)s (where distributions are fully taxable), Roth IRAs/401(k)s (where distributions are tax-free), HSAs, 529s, cash value life insurance, annuities, etc. We’ll approach this by investment type, similar to what we’ve done throughout this “Incoming!” series.
Bonds: Bonds pay interest income, which is considered ordinary income (just like wages you earn from working).
Stocks: Recall that stocks pay dividends, but these can be either qualified dividends or ordinary dividends regarding how they’re taxed. Ordinary dividends are taxed at ordinary income rates. However, qualified dividends are taxed at long-term capital gains (generally more favorable) and include those paid by US companies, companies in countries under US tax treaties, or foreign companies whose stock is easily traded on a US exchange.
But, wait, there’s more!: according to Investopedia, qualified dividends “must also meet holding period requirements. The stock must have been held in excess of 60 days during the 121-day period beginning 60 days before the ex-dividend date. In the case of preferred stock, the stock must have been held in excess of 90 days during the 181-day period beginning 90 days before the ex-dividend date if the dividends are due in a period of time longer than 366 days.”
For TBG clients, most of our Dividend Growth companies meet the criteria for issuing qualified dividends once the holding periods are satisfied (not tax advice 😊).
Mutual Funds (open-ended): taxation of mutual fund distributions depends upon what the fund holds as well as timing of underlying investments and trading. If a mutual fund has met the criteria (see above) to receive qualified dividends from underlying stocks, then the fund’s shareholders will receive those qualified dividends as well. Same with short-term or long-term capital gains: whatever the fund incurs flows through to the shareholders.
The interesting aspect is that holding periods for meeting qualified-dividend or long-term capital gain requirements depends on how long the fund has held the underlying investment – NOT how long an investor has held the fund. So, for example, an investor who only owned a mutual fund for a week would still receive qualified dividends and long-term capital gains, depending on the activity within the fund investments.
A note on the “open-ended” part: Open-ended mutual funds are what you think of as a standard “mutual fund.” When investors buy or sell an MF each day, the fund managers need to adjust the holdings to account for those flows, and that can create unwanted trading activity in the fund; e.g., they buy more stocks and bonds to invest inflows and maintain the exposures they want or sell holdings to meet redemptions; note they also use credit lines to help smooth out the daily cashflows. In closed-end funds, on the other hand, the shares are traded on the open market between investors, and no money flows into or out of the fund (it’s “closed”), so there aren’t tax implications associated with daily flows.
ETFs: Aside from the frequency of trading, open-ended mutual funds (MFs) and ETFs pragmatically feel very similar on the surface – both seem like “big pools of money that own a bunch of stuff,” so to speak. But they are very different from a tax standpoint, with ETFs being regarded as more tax-efficient than MFs. Why? There are a few reasons:
- Lower turnover. ETFs are often index funds, so they tend to hold the same securities for long periods.
- When investors buy or sell ETFs, they’re just exchanging shares with one another on the open market (thus more like closed-end funds than MFs). So, they don’t face the “flows” issue that MFs do.
- Because of the creation/redemption process, which is a whole other fascinating discussion (click here if interested) and means that – even when new shares of ETFs are created and redeemed – this can be done in an “in-kind” (aka nontaxable) way.
Beware the K-1! Even one of my friends, an accounting major and a former special agent for the US Treasury, called me last year, totally caught off guard by a 2020 K-1 that showed up in the mail after he’d already filed his 2020 taxes. What was it for? He bought an oil ETF to take advantage of the depressed prices at the onset of COVID. He did well on the trade itself, but he would have rather not done it at all because he then had to file an amended tax return AND explain to his employer (the federal government) that he wasn’t attempting to conceal anything on his original 2020 tax return. So, please keep in mind that certain ETFs – especially those associated with commodities and currencies – will issue K-1s each year, and you’ll have to deal with that during tax season.
Alts: As usual, now that we have a handle on traditional investments, we can point to some differences of Alts on the tax front. Just like the above, if an alternative investment generates interest from loans or capital gains from sales, that will all flow through to end-investors. Other income streams you may find in Alts are royalties (income paid for the use of an asset) and revenue-sharing arrangements; while they can be interesting, they’re typically treated as ordinary income for tax purposes.
One big difference is that Alts often also have return of capital (ROC) transactions (returning money to investors). A typical example is in a real estate fund where an income stream is distributed to investors (and that income is very clearly based on rents from underlying properties), but it’s considered a non-taxable “return of capital.” That’s possible because of depreciation and other underlying costs that can offset the income from an accounting perspective.
In that case, you receive a yield (good), the value of your investment remains about the same or even appreciates (fantastic), and the income payment isn’t taxable (awesome)! That sounds great (and is great) in the current year, but there’s also a No Free Lunch aspect to this equation: ROC also lowers one’s cost basis in their investment. And, when the investment is sold in the future, it results in a larger gain – a gain that can be taxed as ordinary income (especially for non-real estate items) and a concept known as “recapture.” And note that this can also apply to partnerships, including master-limited partnerships (MLPs), so if you’ve owned individual MLP shares, you may already be familiar with a) tax-advantaged income distributions, b) K-1s needed for their tax reporting, and c) recapture.
Don’t Forget to Thank Your Fund Administrators and Custodians
Imagine if you had to keep track of all of your stocks, bonds, mutual funds, and other holdings, decipher which paid interest, dividends, and capital gains distributions, and which were qualified, long-term, short-term, etc. Well, all of the “annoying” tax forms we receive each year (e.g., 1099s, K-1s) help sort out all of that. Not only do custodians help keep our money safe and facilitate the logistics of trading and clearing operations, but they typically serve an administration function to neatly pull together all of that information on our behalf. There are also third-party fund administrators that help with these items (among others) in the Alts space.
Fees
This post is already too long, so I’ll keep this one very brief: distributions from investment funds (MFs, ETFs, Alts, etc.) are already net of fees, as they do not distribute money to investors until those fees are already paid. Thus, on the one hand, it means the expected yields are net of fees, while on the other hand, it means they need to generate a higher gross yield to ultimately deliver that quoted net yield to investors.
The Elephant in the Room: Taxable Gain/loss vs. Total Return
And, now, finally, let’s talk about taxable gain/loss vs. total return – which now should be easy to address, given our newfound wealth of income-distribution knowledge.
In Part 2, we touched on an example of a mutual fund making a 17% capital gains distribution and the price (NAV) of that fund falling 17% overnight. Let’s say the investor put $1000 into that fund before the capital gains distribution to continue with our example below, which implies the distribution of 17% is $170. Their remaining fund value is $830:
From a total return standpoint: the investor put $1000 in the fund but now has $830 in the fund and $170 in cash (from the distribution), which is still $1000. Thus, the investment has neither gained nor lost money, and the total return is 0%. NOT -17%. Performance reporting software (e.g., Tamarac, Black Diamond) will accurately reflect a zero percent total return.
From a taxable gain/loss standpoint: the investor put $1000 into the fund. That is their cost basis. When the $170 distribution is paid, it is taxable, so it remains part of their cost basis. In that case, they have $830 in the fund, BUT they have technically invested $1000 in the fund from a tax standpoint. Thus, the fund will accurately reflect a -$170 or -17% (-$170/$1000) loss at the custodian (e.g., Fidelity, Schwab, Pershing, etc.). If the fund is then sold, the investor receives a -$170 loss that can help offset capital gains from other investments.
Reinvestment Implications
Okay, what if that distribution is reinvested instead of keeping it in cash? Sticking with the above example, the $1000 fund paid $170 in cash. Now there’s (again) $830 in the fund and $170 in cash (for a brief moment), but then that $170 is used to buy more of the fund. The investor has $1000 of the fund, BUT the cost basis has increased to $1170 ($1000 initial investment + $170 reinvestment). The taxable gain loss is still -$170, but the percentage loss impact is reduced just because of math -14.5% (-$170/$1170).
Extrapolating the above, holdings that consistently distribute income can show a taxable loss, even when the total return is substantially positive.
Custodial access is helpful for several things: 1) confirming what you own, 2) viewing transactions, 3) accessing tax forms, and 4) accountants. But, it leaves much to be desired for making sense of one’s portfolio in terms of allocation or performance; THAT is the purpose of performance reporting software.
And What About Market Value?
If the above investment increases or decreases in price, then the taxable gain loss will be relative to the new cost basis – so the higher cost basis from reinvestment can help reduce future capital gains (when the investment is sold). All of this is very similar to the concept of adjusted-cost basis for homeowners: When your home is sold, your cost basis is not only the price you paid for the house but also the additional money added for improvements and other costs over the years. That all raises your cost basis and can help reduce capital gains at the time of sale.
A Note on Timing
With the above in mind, if you know a large distribution is pending from a fund, then (all else being equal) it’s best to wait until the ex-dividend date to make your purchase, as – in a taxable account – you’ll be taxed on the distribution.
Until next time, this is the end of Alt Blend.
Thanks for reading,
Steve
