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End-of-Year Mutual Fund Considerations

Article written by EricBank

If you are considering the purchase of mutual fund shares in the last couple of months of the year, you might want to time your transaction to avoid the fund's year-end distributions. Otherwise, you'll be paying the taxes on those distributions on April 15 of the following year, without any compensating benefit.

Mutual Fund Distributions

Mutual funds are pass-through entities: as long as they pay out substantially all of their annual income, they pass the tax obligation onto you, the shareholder. A mutual fund portfolio has three income sources:

1.    Dividends it receives on the shares it owns

2.    Interest it receives on the fixed income instruments it              owns

3.    Capital gains on the profitable sale of securities

Funds must distribute at least 90 percent of dividends and interest, and 98 percent of capital gains, to avoid excise taxes on the undistributed amounts.

Capital Gains Distributions

The convention is for funds to make annual capital gains distribution in November or, more likely, December. Funds normally announce the record date and amount per share a few weeks in advance. Shareholders at the close of the record date receive the distribution (and in taxable accounts, its accompanying tax obligation). The distribution is not prorated for the amount of time you held the shares beforehand -- you receive the full distribution. One day after the record date, the fund shares trade ex-dividend, their net asset values reduced by the distribution amount. The actual payment occurs a few weeks later, on the payment date -- a date that has no tax significance.

Tax Strategies

Here are some strategies to help you avoid the year-end tax consequences of mutual fund capital gains distributions.

• Ascertain the record date and distribution amount from the fund before buying shares late in the year. If the distribution amount is more than de minimus, wait until the ex-dividend date to make your purchase.
• Before the record date, sell shares that are priced below your acquisition cost. You can take a loss on those shares and avoid the capital gains distribution on them. 
• If you are an index trader, consider using index ETFs instead of index mutual funds. ETFs follow special procedures, called the creation/redemption mechanism, mainly to ensure that the share price is kept very close to the share net asset value. However, another benefit of this mechanism is that it frequently allows the ETF to shed profitable shares tax-free. Some index ETFs haven't paid capital gain distributions in years. Another factor for active traders: you can sell ETF shares at any time -- open-end mutual fund companies sell and redeem share after trading hours. Therefore, ETFs are more suitable to active traders, especially day traders.
• Because most mutual fund shares are held for investment, it makes sense to park those shares in an IRA or other non-taxable account. If you use a Roth account and follow the rules, you can avoid taxes on all withdrawals.
• Most stock dividends qualify for capital gains rates, and that includes stock dividend distributions from mutual funds. However, any distribution of stock dividends you receive from mutual fund shares that you hold for investment will be subject to ordinary tax rates if you fail to hold those shares for at least 61 days surrounding the ex-dividend date.

Tax Selling

Article written by EricBank

As the end of each year approaches, the opportunity arises to evaluate your portfolio, winnow out the laggards, reap some of the winners and perhaps select new investments. Part of this strategy is tax-related. Let's review the capital loss rules and the special tax breaks available to active securities traders.

Capital Gains and Losses

One thing that distinguishes the tax treatment of investors versus traders is the handling of gains and losses. The capital gains tax rates range from zero to 20 percent, depending on your ordinary tax bracket:

Tax Bracket	Over	To	Capital Gains Rate
10%	$0	$9,075	0%
15%	$9,075	$36,900	0%
25%	$36,900	$89,350	15%
28%	$89,350	$186,350	15%
33%	$186,350	$405,100	15%
35%	$405,100	$406,750	15%
39.60%	$406,750		20%

Figure 1 Capital Gains Rates -- Single Taxpayer

These rates apply to long-term capital gains (on holdings longer than one year) and on qualified dividends. Capital losses offset capital gains and up to $3,000 of ordinary income. You can carry unused losses forward to offset income in future years. Interest income is subject to ordinary tax rates.

Strategy

In a tax-selling strategy, you couple the sale of winners and losers so that the losses offset, and perhaps exceed, the gains. If you don't have enough losses to fully offset your gains, you might be able to use carryover losses from previous years. You also might hold off on selling winners until early in the new year to avoid income in the current year.

The wrinkle in this strategy is that any short-term capital gains are taxed at normal rates, which makes pairing to losses even more important. If you sell holdings consisting of long-term and short-term tax lots -- some of the purchases occurred more than a year ago -- you can juggle the selection of long-term and short-term gains to get the maximum benefit from your capital losses, especially if you also have ordinary income.

Mark-to-Market Rules

If you are an active securities trader, you can choose mark-to-market accounting, which will change the way you report gains and losses. Recall from our blog on wash sales that the IRS will consider you an active securities trader if:

.   You seek profits from daily market movements in prices

.   Your activity is substantial

.   Your activity is continuous and regular

As we have pointed out, MTM accounting treats your holdings as if you sold and repurchased them at the closing market prices on the last trading day of the year, thereby realizing gains and losses. If you take this route, your gains and losses are subject to ordinary tax rates, not capital gains rates. The main benefit from this rule is that you are not bound by the $3,000 cap on applying current year trading losses to ordinary income, as you would be by capital losses. Your trading losses are business losses and you report them as such. Of course, MTM accounting negates tax-selling strategies, since you, in effect, sell everything on the last day of the year.

One other benefit is that you can deduct investment interest expense in full -- it is not capped by investment income. This is useful when you have other sources of income in addition to your trading income, because you can offset these as well.

The Medicare Tax and Active Traders

Article written by EricBank

Most folks have to pay Social Security and Medicare taxes on their income. A 3.8 percent Medicare tax is levied on taxpayers who reach certain thresholds for modified adjusted gross income (MAGI) or net investment income (NII). Self-employed individuals must pay self-employment tax to cover their Social Security and Medicare obligations. The good news is active traders, as defined by the IRS, do not pay self-employment tax on the income from their active trading business. The bad news is that you don't accumulate Social Security income when you avoid self-employment tax, meaning you might receive very meager Social Security checks when you retire.

How the Tax Works

The IRS levies a 3.8 percent Medicare surtax on the lesser of NII or the excess of MAGI above $200,000 for individuals, $250,000 for couples filing jointly, and $125,000 for spouses filing separately. NII applies to net rental income, dividends, taxable interest, net capital gains, royalties, passive income and the taxable portion of nonqualified annuity payments. NII does not include tax-exempt interest from municipal bonds and withdrawals from retirement plans/pensions. Social Security benefits, life-insurance proceeds, veterans' benefits, and income from businesses in which you actively participate, are also excluded from NII. MAGI includes NII, W-2 wages and income from retirement plans.

Active Traders

As we always like to point out, to be an active trader as defined by the IRS, you must clear three hurdles:

·       You seek profits from daily market movements in prices

·       You maintain substantial trading activity

·       You are continuously and regularly active as a trader

The IRS examines the facts and circumstances surrounding your trading activity to surmise whether or not you are an active trader. They look at trade frequency, trade size and the amount of time you devote to trading, among other things. Your security or commodity trading needs to be a means of livelihood, not an avocation.

Mark-to-Market and 1256 Trades

As an active trader, you can elect mark-to-market accounting rules, in which case your gains and losses are ordinary, not capital. As an active trader, you don't pay self-employment tax on your active-trading income, whether or not you elect MTM. However, if you engage in Section 1256 trades, the income from these trades is subject to self-employment tax. Section 1256 applies to certain commodity contracts such as futures, FOREX and non-equity options. If you are a commodity trader who (a) regularly trades 1256 contracts and (b) is registered with a domestic board of trade, this results in a self-employment tax obligation on any resulting income. [See http://www.taxresourcegroup.com/library/memo/1284.html

Other Factoids

If you run your trading business as a Subchapter S, the income eligible for payroll taxes is not subject to self-employment taxes, but certain profit distributions are. If you run your trading business as a C corporation, NIIT would only apply to corporate dividends, and the disposition of ownership stock. You face many considerations when deciding how to set up your active trading operation -- Traders Accounting can provide you valuable advice and services to set you up in the optimal trading vehicle

Ah Mondays....

Traders' Exemption From Wash Sale Rules

Article written by EricBank

The U.S. tax rules contain a number of incentives for securities traders and dealers that are not available to investors. By "trader," we mean someone who is engaged in the business of trading securities (and/or commodities), as defined by the IRS:

.   You seek profits from daily market movements in prices

.   Your activity is substantial

.   Your activity is continuous and regular

The IRS applies a set of criteria to evaluate the facts and circumstances surrounding your self-identification as a securities trader, but let's assume for this article that you qualify. One of the perquisites you'll receive is the suspension from wash sale rules, but only if you adopt mark-to-market (MTM) accounting procedures. Let's take a closer look at wash sale and MTM rules to better appreciate the benefits a trader receives.

Wash Sales

Normally, investors must postpone tax-deductions on trading losses if they buy the same security 30 days before or after selling it. This applies to long and short trades:

Example 1: Long Trade

You buy 1,000 shares of ZZ Corp for $10,000 on February 1. On August 13, you sell the shares for $9,500, and normally you would use the $500 loss to offset other capital gains and up to $3,000 of ordinary income. However, you decide to repurchase the 1,000 shares on August 22. That makes the August 1 transaction a wash sale. You must now instead add the disallowed loss of $500 to the cost basis of your August 22 shares, which has the effect of postponing the tax benefit from the loss until you later sell those shares.

Example 2: Short Trade

You borrow and short 500 shares of YY Corp, receiving $5,000 in proceeds that your broker locks up in your margin account. To your horror, the stock starts rising, and you buy it back to cover the short sale one month later, on June 7, for $6,000, a $1,000 loss. The loss will be subject to the wash sale rule if you short the stock again within 30 days of June 7.

Wash sale rules also apply to if you reinvest a mutual fund dividend within 30 days of selling the mutual fund shares for a loss. In addition, wash sales rules apply to repurchases (or re-shorts) made in a retirement account within 30 days of a loss on the same security in a taxable account.

The IRS helpfully points out in the instructions to Form 4797, page 2, that, as a trader of securities, you can avoid the wash sale rules by marking to market.

Marking to Market

You can inform the IRS that you've elected mark-to-market accounting by including a statement with your tax return stating:

1.    You are making the MTM election under IRC 475(f)

2.    The tax year when the election is to become effective

3.    The name of your trading business

MTM accounting calls for you to act as if you sold and repurchased all your holdings at the closing market prices on the last trading day of the year. In effect, you are realizing an ordinary gain or loss on positions that otherwise would have unrealized gains and losses. You'll pay the current-year taxes on the phantom sales and use the MTM prices as the new cost bases for the securities going into the new year.

Traders Accounting will be happy to assist you to set up as a securities trader and handle all your MTM processing.

Tax Man