Lipper Research Senior Analyst Don Cassidy on "Business for Breakfast" 1060 KRCN Tuesday - Year-end Thinking For Tax Purposes
Tuesday, December 13, 2005
Q. Don, here it is mid-December--and of course that brings thoughts oftidying up our investments for tax purposes. How does that apply to ourmutual fund holdings?A. There definitely is a good deal to look at, and I want to start bysaying that people should consult their own experts on the tax aspects.
Q. Right. Of course! But how about the investment considerations withfunds?
A. I think there are three main drivers that people should consider:
Q. Okay, let's start with the rebalancing idea...
A. Sure. Whether it's year-end that's coming, making an annual IRAcontribution, or whatever, I think every event that causes investors tore-examine their situation is a good thing. We tend to neglect reviewingbecause it can cause stress. But if we do not review periodically, we aresimply collectors, and some of that old stuff can be pretty badly out ofplace after awhile, like in your clothes closet or your kids' toys!
Q. Okay, so where should listeners start?
A. I think there are two main approaches. One is mechanical. I use the"Rule of 110"--subtract your age from 110, and that is the rough percentageof your investments that should be in equity funds and individual stocks.Compare that number with where you are; you will at least know for starterswhether you should be (net) buying or redeeming equity funds or bond funds.Then, Number 2, I would ask a challenging question of myself...
Q. Like what?
A. Assuming your asset allocation is okay, would you buy this fund (orstock) again today if you had some cash and did not own it already?
Q. That should clear away some cloudy thinking!
A. Exactly the purpose!
Q. Okay, on to the dead wood issue, and we don't mean South Dakota.
A. People have a very hard time selling, because it can mean admitting apast mistake, because it ends any hope for future improvement, and becauseit means they need to make a second decision--on what to replace the solditem with.
Q. A pretty heavy load of baggage!
A. Right. So, again I would start with the acid test (would you buy ittoday?). But I do think the question should be a lot easier for people infunds than it is for people with individual stocks.
Q. Why's that?
A. In funds you have excellent benchmarks, and it is easy to compare fundsto see how they are doing against their peers. Not every stock has a purecomparable; even PepsiCo and Coca-Cola are different. And what would youmatch GE up against? And funds do not have the emotional content--thevividness--that stocks do. So it should be easier to let go.
Q. And under what circumstances would you "let go"?
A. I'd be inclined not to let a short-term loss go long term (over 365days), since it loses some of its tax value. I would use that as onetrigger. Also, I think a year is a long-enough period in which to be "fair"in judging whether a fund is performing well enough against itscomparables. There are no temporary performance-altering special eventslike one-time write-offs, new products, and so on to complicate thecomparison process as there can be with stocks.
Q. And, with funds, it is pretty easy to find an equivalent, right?
A. Exactly! If you have a technology fund that's still underwater, thereare literally over a hundred others you could substitute and still have atax loss be valid, while staying represented there for some more recoveryif you wish. Ditto for large-cap funds, with many hundreds available. Itshould not be a hard thing to pull that trigger. A fund (or stock) at aloss is worth more sold than held, since you get federal and state taxbenefits for the loss. So, you then have more money to reinvest, to improveyour wealth with, going forward.
Q. Besides lagging performance, which is easy to measure (LipperLeaders.com!), what other factors might make you sell?
A. A change in subtle emphasis of the fund (more- or less-aggressive, orstyle drift). A manager change, if you bought at first because of the starrunning the show then. And of course you might realize that other kinds offunds are moving or seem to have better prospects going into the new year.Or you may have collected more than one fund doing the same kind of work;diversify properly, then. Maybe get more international if you have notalready done so.
Q. Okay, and you mentioned timing your year-end moves...
A. Right. Some funds will be making distributions before year's end. Youwill not know the exact amounts and the type (short-term versus long-termgains) until maybe in January! You can get rid of that uncertainty byredeeming the fund shares before they pay that next distribution. There isno free lunch: the fund's NAV will drop by the amount of the dividend, sothere is no reason to wait to get it. Just as you would avoid buying theyear-end distribution, you would sell before the XD date too, if you aregoing to sell anyway.
Q. Any other tax things to think about, here at year's end?
A. Definitely! When you sell a fund, if you have been reinvestingdistributions, do not forget to include all those reinvested amounts on topof your original cost to get the true tax cost basis of your sale when youreport your taxes. Otherwise, you will accidentally pay too much in taxes.It's easier to get it right the first time than to file an amended returnlater!
Q. Do you think distributions will be really big this year?
A. Clearly higher than in '04, since more gains have come to roost and moreloss carryforwards have been used up--not a record, but almost surely thelargest overall since 2000. And of course some types of funds will pay bigamounts, while the less-favored sectors will show less.
Happy "sprucing" up for the holidays!
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Don Cassidy is a Senior Research Analyst at Lipper specializing in fund flows, exchange-traded funds, (ETFs), closed-end funds, equity fund performance, and author of Trading on Volume (McGraw-HIll).
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