Weblog
Making Lemonade
2008 has delivered a lot of lemons, and not much sugar. We’ll have to content ourselves with just a little bit of lemonade.
The half-glass of lemonade I’m pouring today includes an exploded investing myth and a $1,400 tax tip that everyone can use. (Please see my Terms of Use - I’m not an accountant)
First – our myth
I’ve had quite a few conversations with investors who are afraid to trade lousy, loss-ridden mutual funds for fear that they will miss out when the market “bounces back.” The obvious problem with this argument is that yesterday’s losers may not be tomorrow’s winners. Many tech stocks hammered in 2000 did not ever bounce back.
The more subtle and interesting problem is mutual fund turnover. Most investors buy and hold mutual funds for long periods. The 1099 forms they receive each year go to their accountant along with their (much larger) W2, and they either get a refund or make a payment without thinking much about why their “buy and hold” strategy is sticking them with a tax bill. Turns out that mutual fund managers are furious traders, buying and selling stocks at a breakneck pace, and it’s THEIR trading with YOUR money that determines the taxes that you pay.
The average mutual fund turnover is 85% per year. If you’re curious about a particular fund, Yahoo Finance includes Turnover data. Use the left navigation to choose Fund > Profile, then look on the right under Fund Operations. You can see that Fidelity Magellan’s 57% turnover is below the category average of 97%.
The bottom line is that mutual funds that did worse than the market do not own the same stocks they lost your money with – they own different stocks that may once again lose to the market. So don’t be afraid to get rid of lousy funds, especially if you’re doing it within the context of a new and genuinely strategic approach to your savings.
As an FYI, the quasi-index funds I use have turnover of 5-14%. It’s difficult to go lower than this because M&A forces some turnover.
Second – a (related) tax tip (note my Terms of Use - I’m not an accountant)
By selling your lousy funds and losing stocks, you can bank a large capital loss, and each year you can deduct $3,000 of capital losses from your income. You can carry these losses forward as long as you live, taking $3,000 off your taxes every year you continue to have more losses than gains.
Let’s explore how this works with an example:
- All of your money is invested in the Fidelity Contrafund mutual fund. Your original investment, made a few years ago, was $100K. Now it’s worth $60K. You choose to sell it all and reinvest the proceeds elsewhere. You now have $40K in capital losses, more or less.
- You take $3K off of your income taxes. This is “above the line,” meaning you get this deduction even if you don’t itemize your deductions (such as if you don’t own a home).
- You carry $37K in losses forward to be subtracted from the cap gains portion of future 1099s.
- Your $3K reduces your actual taxes by around $1,400 (i.e. the taxes you would have paid on the $3K in income that you sheltered with your $3K capital loss).
- You buy one each of a Nintendo Wii, a Four Seasons Spa gift certificate, and a Rolling Stones genuine imitation framed gold record. Happy holidays.
Note what’s happening here: the government is actually subsidizing your stock market losses by giving you a tax credit in $3K increments. This may not seem like much, but it’s still free money for very little effort.
If you switch to a low-turnover strategy at the same time (as my clients do), you can avoid significant capital gains taxes for the next 20 years, enabling you to stretch out your capital losses and potentially recoup much of them from the government.
