The Herald Bulletin

June 15, 2013

'Big Joe' Clark: Taxed today and gone tomorrow

The Herald Bulletin

---- — Volatile markets lead to ulcers, hyper tension and nervous reactions as well as a good dose of excitement. Fear and greed tend to drive all markets and with money managers underperforming most indices it is very easy for people to forget the plan and jump on to the ride. The emotional thrill of market gains is hard to deny but don't forget the IRS standing in the corner.

Large swings within the market have become more common than many of us would like. As investors see an increase in volatility their natural reaction is fear which can lead to emotional decisions within their investment accounts. The volatility caused panic by some and large withdraws by others from mutual funds. Mangers of funds often have to sell to cover the withdraw requests in order to meet the redemption requests by investors. There is much confusion regarding mutual fund taxation but you do indeed get 1099 tax forms for gains inside of mutual funds even if you didn't sell.

The gains are often referred to as phantom capital gains. You buy a fund with a $10 net asset value and you own a unit of the fund or technically the trust. People like to say that you own the underlying shares held inside the mutual fund but that is not accurate.

Let’s say you have a great manager who bought stock ABC in January for $25 a share. The market had a great run and suddenly ABC was trading at $40 per share. You jump in and make your investment in the fund in June at $10 per unit. Now let's pretend there was big market volatility after you purchased your shares. Your investment falls to $8 but you don't sell. You have a realized loss on paper but not a recognized loss since you didn't sell. Some of your fellow investors did sell and your mutual fund has to raise cash.

ABC fell from $40 to $35 and the manager sold the shares to raise some cash to take care of fleeing investors. The stock is less today than when you bought in but the fund bought the shares at $25 which means they have an internal gain. As an owner of the trust you get to recognize that gain on your tax return! Congrats.

This is important in volatile and questionable markets. It has happened before and it’s likely to happen again. Late in 1999 the market turned ugly and some investors sold producing capital gains inside of mutual funds. You get a tax bill due the next April. The problem is the tech wreck started in March of 2000 and you were now paying taxes on money you no longer had due to the market correction. That's a double whammy!

This is not written to tell you the market is collapsing and obviously has nothing to do with retirement or IRA accounts but you do need to know that volatility can lead to more than just excitement and frustration. Volatility creates taxation. Stick to your plan but also understand your exposure to both risk and taxation.

Joseph “Big Joe” Clark, whose column is published Sundays, is a certified financial planner. He can be reached at or 640-1524.