Avoid phantom income when investing in mutual funds

With a new year underway, many individuals will identify new financial goals for the year ahead. One common goal, developing an investment strategy, is an important element of planning for your financial future. There are thousands of options for how to invest your money wisely, but not all of these options will yield positive results. Mutual funds are a popular option to consider, but investors should proceed with caution.

After investing in a mutual fund, there are many components to be aware of. A lesser known phenomenon plagues many investors, who often are blind to its occurrence: phantom income. Phantom income is a concept that refers to shareholders’ capital gains distributions being automatically reinvested by the mutual fund, without the shareholder ever seeing it.

Mutual fund managers are continuously buying and selling securities inside of their funds. As a result, shareholders may become subject to capital gains on their taxes at either long- or short-term rates depending on the length of time the mutual fund held the underlying security. This is all based on the income they haven’t received. The practice occurs near the year’s end and catches many shareholders by surprise.

Taxes on phantom income may be more common than you think. When a mutual fund you own in a taxable account loses money, but capital gains are redistributed, the funds are realized by the IRS even though you have personally lost on the investment.

To break down this concept, imagine you invested $100,000 in the ABC Disciplined Equity Mutual Fund at the beginning of 2018. At the close on Dec. 31, your fund was down 10.06 percent, leaving you with $89,940 in your account.

It’s clear, in this example, you have lost a significant amount of your investment — but that’s not all. In December, there was a capital gains distribution of 18 percent ($16,189) that was reinvested into the fund, unbeknownst to you, the shareholder. The investment didn’t change your fund’s value at all, but it means you will get taxed at a 20 percent long-term capital gains rate — an increase of $3,237 to your tax bill. This ultimately means a loss of over $10,000.

In a scenario such as this, which is seen all too often, an adviser would have recommended the investor sell the ABC Disciplined Equity Mutual Fund before the distribution was effective and reinvest elsewhere. This simple move would have avoided the additional taxes and provided a $10,060 short term capital loss — $3,000 of which would have been deductible against their ordinary income. The shareholder could have then used the remainder to counter any other capital gains this year or in years to come.

Unfortunately, these capital gain distributions are all too common. In 2018, many mutual funds distributed over 20 percent of their net asset value as capital gains — one going so far as to distribute 89 percent.

Investing is an important element of financial planning but must be executed with caution. It is recommended that investors work with an advisory team comprised of both tax CPAs and financial advisers working together. In doing so, you will make informed decisions and avoid the threat of phantom income/gains in the future. Planning for your financial future is not easy, but with trusted advisers on board, it is possible to navigate the unpredictable financial climate with some certainty.

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<a href="https://www.rehmann.com/about/the-rehmann-team/item/124-ronald-knipping">Ron Knipping</a>, CFP is a principal and financial adviser in <a href="https://www.rehmann.com/">Rehmann</a>’s Grand Rapids office. He is a regional director for Rehmann Financial and serves on its executive committee. Knipping has extensive experience developing programs for high net-worth individuals, families, foundations and endowments, as well as retirement plans for corporations, nonprofits and the public sector. He has obtained numerous securities registrations and insurance licenses over his career. He holds a B.S. in general engineering, with a concentration in economics, from the U.S. Military Academy in West Point, New York and an M.B.A. from the University of Michigan.

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