This tax season there’s a clever little word popping up on social media about how tax preparers can deliver bad news to customers: Congratulations.
According to Urban Dictionary, this is a term you might give to a co-worker who has accepted a job promotion that is a mixed blessing. Say something that moves her up the ranks but clearly puts her in more direct contact with a fiery ally.
Congratulations on your success. Condolences for what’s next.
Enrolled agent Matthew Cordes said in a light-hearted tweet, “I think I’m going to use this with clients who have to pay a huge tax bill because they made a lot of money.”
Eye-popping numbers for taxable income are being placed before investors and others who saw financial success in 2021, often triggering tax scenarios and tax bills that many never imagined.
A Million-Dollar Moment Triggers Big Tax Headaches
Blame bitcoin and virtual currency. Blame a lot of trading in stocks. And yes, blame mutual funds that paid some extraordinary capital gains distributions after a strong rally on Wall Street last year.
The Standard & Poor’s 500 grew about 26.9% in 2021. The Dow Jones Industrial Average climbed 18.73% in 2021. And your tax bill?
Big gains can mean big money at tax time.
James O’Rilley told me about an investor who made over a million dollars in virtual currency buying and selling almost daily last year.
According to O’Reilly, a CPA and tax director for Doreen Mayu in Troy, the man — a friend of a friend who wasn’t aware of all the tax implications — was shocked by the result.
He had taken an early retirement — or so he thought, O’Riley said — but then owed more than $400,000 in federal taxes for 2021 on his virtual currency gains.
Gains in excess of $1 million last year were short-term gains, which are taxed at regular income tax rates. In this case, the money was taxed at a top rate of 37% and a “net investment income tax” of 3.8%.
“The problem is that the portfolio’s value is significantly reduced in 2022 to the point where it only needs to sell the entire portfolio to pay taxes,” O’Riley said.
One small plus side to this story: The investor lives outside of Michigan and in Florida, which does not have state income tax. There would have been even more money owed at the state level if the person betting on bitcoin lived where the state income tax is.
Mutual fund investors get caught up in unusual capital gains
However, being a day trader didn’t have to be in order to face the tax headache. Even passive investors saw incredible tax trouble.
A reader told me that he has been investing in mutual funds for almost 30 years and doesn’t remember anything like that.
For 2021, their capital gains distributions from their mutual funds outside tax-deferred retirement accounts increased by a staggering 82,000 in 2020.
And as a result, the couple reported $115,000 in capital gains distributions on their 2021 return.
The retired couple living in the Traverse City area saw their federal and Michigan state tax burden rise to $20,000 this tax season.
Fortunately, the couple — who asked not to be named because they didn’t want others to read about their finances — were able to pay and didn’t have to borrow money to cover the taxes due.
Cordes, who prepares about 650 individual returns annually, told me about an elderly client who typically reported $5,000 to $8,000 in taxable capital gains distributions from mutual funds held outside tax-deferred retirement accounts. Have to do
This year, the client had to report $55,000 in taxable capital gains distributions.
“His tax due this April 18 is over $11,000.”
Cordes has heard that customers elsewhere are also facing huge tax bills because of the massive capital gains distribution. “But my client base isn’t the highest in net worth,” said the tax preparer who lives in Garrett, Indiana, north of Fort Wayne.
These “surprise” tax bills include capital gains distributions from mutual funds held outside of a traditional 401(k) or tax-deferred IRA.
“Most taxpayers don’t realize that mutual funds must distribute capital gains within the fund,” Cordes said.
“Those capital gains are reinvested and nothing is ‘received’ as cash payments to the taxpayer,” he said.
What you get for reporting those capital gains distributions from mutual funds is a 1099-DIV. Usually, they are dispatched at the end of January.
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Good rally shares some faults
According to Fidelity Investments, a strong rebound in the stock market in the second half of 2020 after a slowdown at the start of the pandemic and big gains last year resulted in larger-than-usual distributions for many funds.
According to a Fidelity spokesperson, “Periods of extended rising equity markets will naturally result in higher distributions as fund managers are less prone to losses to offset gains.”
According to Chicago-based Morningstar Direct, a research firm, about 53% of mutual funds based in the United States, including exchange-traded funds, reported capital gains distributions for 2021. This was up from 43.1% in 2020.
Morningstar noted that 5,405 mutual funds reported capital gains in 2021, compared to 4,234 in 2020.
How much funds pay for such distributions varies from year to year. Going back to 1990, based on Morningstar Direct data, spikes where capital gains distributions in 60% or more of mutual funds were relatively rare and occurred in 1993, 1997, 1998 and 2007.
During that time, we saw four years — 2002 and 2003, as well as 2009 and 2010 — when only 25% or less of the funds had such distributions.
The dollar amount of the distribution, however, can shock investors who have been saving a lot in mutual funds for decades.
Some funds distributed 10% to 20% or more of their net asset value — which can add up to four or five figures of income in an investor’s 1040 this tax season.
Take this simple math example. If you had $10,000 in mutual funds outside of a retirement account, you would have an additional $1,000 in taxable capital gains income when a fund had 10% capital gains distributions.
Over the years, many investors have saved a lot in taxable mutual funds held outside retirement accounts. In those cases, you are looking at taxable income when the mutual fund has capital gains distributions.
For many retirement savers with 401(k)s and IRAs, it’s a non-event if the mutual fund is in a tax-sheltered account. You are hit with taxes when you start withdrawing money from traditional retirement accounts. Qualified withdrawals from a Roth IRA are not taxable.
Capital gains distributions can be described as short-term or long-term, depending on the investment strategies of the mutual fund.
For a taxpayer, a short-term distribution will be taxed at the individual’s ordinary income tax rate. There are currently seven income tax rates at 10%, 12%, 22%, 24%, 32%, 35% and the highest at 37%.
In general, the more active a fund manager is with trading, the more likely it is that the fund will deliver short-term profits. As a result, investors may find it more beneficial to hold funds with higher turnover rates in tax-sheltered accounts such as traditional IRAs and Roth IRAs, according to Fidelity.
Taxpayers get a break on long-term distributions. Long-term capital gains tax rates are 0%, 15% and 20%, depending on your income.
Mutual fund companies started publishing estimates for capital gains distribution to be made in mid-December last November. But the funds can pay out distributions throughout a year.
According to Fidelity, these “off-cycle” distributions may be the result of a fund merger or investment mandate change.
Growth funds made significant distributions again, according to Morningstar experts Christopher Franz and Anthony Thorne, but value strategies gained popularity in 2021 and some took some larger distributions.
Experts at Morningstar note that it’s not all pain, as reinvested capital gains distributions will increase your cost basis and ultimately reduce your capital gains taxes when you sell the fund.
“The cost of selling it may be lower than you anticipate in the future, thanks to all cost-basis moves that have begun regular distributions,” experts wrote in a capital gains round-up in late November.
After this year’s surprise, however, many investors will undoubtedly pay more attention to the risk of a potential tax surprise if you are holding an actively traded mutual fund outside of a tax-deferred retirement account.
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