A clever little term is being joked around on social media this tax season to describe how tax preparers can break bad news to clients: Congratulations.
It’s a word you could offer, according to the Urban Dictionary, to a co-worker who has accepted a job promotion that is a mixed blessing. Say something that will move her up the ranks but clearly put her in more direct contact with a curmudgeonly colleague.
Congratulations for your success. Condolences for what is to come.
“I think I’m going to use it with clients who have to pay a big tax bill because they made a lot of money,” registered agent Matthew Cordes said in a cheerful tweet.
Staggering numbers for taxable income are being presented in front of investors and others who saw financial success in 2021, often to trigger fiscal scenarios and tax bills that many never imagined.
A million-dollar moment triggers a major fiscal headache
Blame it on Bitcoin and the virtual currency. Blame it on stock trading. And yes, blame the mutual funds that paid out some extraordinary capital gains distributions after a sharp rally on Wall Street last year.
The Standard & Poor’s 500 Index is up nearly 26.9% in 2021. The Dow Jones Industrial Average is up 18.73% in 2021. And your tax bill?
Big wins can mean big money at tax time.
James O’Rilley told me about an investor who made over a million dollars buying and selling virtual currency almost daily last year.
The man, a friend of a friend who was unaware of all the tax ramifications, ended up surprised by the outcome, according to O’Rilley, a certified public accountant and tax director for Doeren Mayhew in Troy.
He had taken early retirement, or so he believed, O’Rilley said, but then owed more than $400,000 in federal taxes for 2021 on his virtual currency earnings.
Earning more than $1 million last year was equivalent to short-term earnings that are taxed at regular income tax rates. In this case, the money was taxed at the maximum rate of 37% plus a “net investment income tax” of 3.8%.
“The problem is that the value of the portfolio has dropped substantially in 2022 to a level where you need to sell the entire portfolio just to pay the taxes,” O’Rilley said.
A little silver lining to this story: The investor lives outside of Michigan and in Florida, which has no state income tax. Even more money would have been owed at the state level if the man who gambled in Bitcoin lived where there is a state income tax.
Mutual Fund Investors Hit by Unusual Capital Gains
However, one did not need to be a day trader to face tax headaches. Even passive investors saw incredible tax problems.
A reader told me that he’s been putting money in mutual funds for about 30 years and doesn’t remember anything like this ever happening.
For 2021, your capital gains distributions from your mutual funds outside of tax-deferred retirement accounts increased by $82,000 in 2021 from 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 Michigan state and federal tax burden increase by $20,000 this tax season.
Fortunately, the couple, who asked not to be identified because they did not want others reading about their finances, were able to pay and did not have to borrow money to cover the taxes owed.
Cordes, who prepares about 650 individual returns a year, told me about an elderly client who would typically have to report $5,000 to $8,000 in taxable capital gains distributions from mutual funds outside of tax-deferred retirement accounts.
This year, the client had to report $55,000 in taxable capital gains distributions.
“Your tax due this April 18 is over $11,000.”
Cordes has heard of clients elsewhere facing even higher tax bills due to massive capital gains distributions. “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 involve 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 that are realized within the fund,” Cordes said.
“Those capital gains are then reinvested and the taxpayer does not ‘receive’ anything in the form of a cash payment,” he said.
What you would get is a 1099-DIV to report those mutual fund capital gains distributions. They are usually shipped at the end of January.
The good rally shares some of the blame
The strong rally in the stock market in the second half of 2020 after the crash at the start of the pandemic and sizeable gains last year resulted in larger-than-normal distributions for many funds, according to Fidelity Investments.
“Prolonged periods of rising equity markets will result in higher distributions, as fund managers are less likely to take losses to offset gains,” according to a Fidelity spokesperson.
Some 53% of US-based mutual funds, including exchange-traded funds, reported capital gains distributions for 2021. That was up from 43.1% in 2020, according to Morningstar Direct, a research firm. Chicago-based research.
Morningstar noted that 5,405 mutual funds reported capital gains in 2021, compared to 4,234 in 2020.
The amount of funds that pay such distributions varies from year to year. Based on Morningstar Direct data going back to 1990, the spikes in which roughly 60% of mutual funds had capital gains distributions were relatively rare, occurring in 1993, 1997, 1998 and 2007.
During that time, we saw four years, 2002 and 2003, as well as 2009 and 2010, in which only 25% or less of funds had such distributions.
However, the dollar amount of the distributions may surprise investors who have been saving heavily in mutual funds for decades.
Some funds distributed 10% to 20% or more of their net asset value, which can add four or five figures of income to an investor’s 1040 this tax season.
Take this simple mathematical example. If you had $10,000 in a mutual fund outside of a retirement account, you would have an additional $1,000 in taxable capital gains income when a fund has a 10% capital gains distribution.
Over the years, many investors have accumulated quite a bit of savings in taxable mutual funds that are kept outside of retirement accounts. In those cases, it is taxable income when a mutual fund has a capital gains distribution.
For many retirement savers with 401(k)s and IRAs, it’s not an event if the mutual fund is in a tax-sheltered account. You’re getting hit by taxes when you start withdrawing money from traditional retirement accounts. Qualified withdrawals from Roth IRAs are not taxable.
Capital gains distributions can be characterized as short-term or long-term depending on the mutual fund’s investment strategies.
For the taxpayer, a short-term distribution would be taxed at the individual’s ordinary income tax rate. There are seven income tax rates currently 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 the fund is to distribute short-term gains. As a result, investors may find it more advantageous to hold funds with a higher turnover rate in tax-sheltered accounts such as traditional IRAs and Roth IRAs, according to Fidelity.
Taxpayers receive a discount on long-term distributions. Long-term capital gains tax rates are 0%, 15%, and 20%, depending on your income.
Mutual fund companies began publishing estimates last November of capital gains distributions likely to be made in mid-December. But the funds can pay distributions over a year.
These “out-of-cycle” distributions may be the result of a fund merger or a change in investment mandate, according to Fidelity.
Growth funds again made significant distributions, but in 2021 value strategies gained popularity, causing some to make large distributions, according to Morningstar experts Christopher Franz and Anthony Thorn.
Morningstar experts noted that it’s not all pain, as reinvested capital gains distributions will increase your cost base and ultimately could reduce the capital gains taxes you owe when you eventually sell the fund.
“Selling it in the future may cost less than you expected, due to all the increases in the cost base that regular distributions triggered,” the experts wrote in a statement. capital gains rounding at the end of November.
However, after this year’s surprises, many investors will no doubt pay more attention to the risk of a potential tax surprise if you have an actively traded mutual fund outside of a tax-deferred retirement account.