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Imagine, it’s early-February, your investment account was down a couple dozen percent last year, but you managed to hang on and never bought or sold anything. As you are patting yourself on the back for not letting fear dictate your investment strategy, you receive a letter from your broker, it’s your 1099. As you open the letter and read, you notice a line called “Total Capital Gain Distributions”. And it’s a big number! How can there possibly be capital gain tax owed, when your account is down, AND you never bought or sold anything!?!
When you own a mutual fund or ETF, you own a basket of stocks, bonds or other investments. Throughout the year the investment manager will buy and sell investments, either to match an index, get better returns, more safety, or other reasons. When these investments are sold at a gain, the investors, you, owe tax on that transaction at the end of the year. Yes, this still happens in index funds, ETF’s and mutual funds.
Keep in mind, this process still happens inside retirement accounts like IRA’s and 401k’s, you just won’t owe any tax on the capital gain distributions.
When selecting which funds you want to invest in, it is important to keep the tax effect in mind. It’s not what you make, it’s what you get to keep. It is often a good idea to keep investments with higher distributions and dividends in your qualified accounts like IRA’s or 401ks, but everyone is different. If you would like a CERTIFIED FINANCIAL PLANNERTM to give you a no cost, no obligation second opinion on your investments, give us a call or email and we can talk about your personal situation.