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Income Tax Planning

Tax Planning – A Difference Maker


There are a number if financial and tax considerations when using mutual funds as an investment tool. One thing that I have experienced is that most of the investment advisors and financial planners that I know, or have met, do not discuss the tax inefficiencies and hidden costs associated with mutual funds. Most investors have heard of 12(b)(1) fees; but, they are not aware of the many other costs charged by mutual funds.

In this blog however, I am going to discuss one of the biggest and least discussed inefficiencies in mutual fund investing, embedded capital gains. As a formal tax planner and Tax Minimization Strategist, I believe that it is critical that clients be aware of the fact that there are embedded capital gains and losses in a mutual fund investment the day they purchase the fund, and, if the fund is performing with much success, the embedded gains are greater than the embedded losses. What is an embedded gain you ask? It is simple, when you purchase the mutual fund, you inherit the basis of each security owned by that fund at the time you purchase the fund unit. For example, you purchase ABC mutual fund at the close of business today. The fund owns Apple Stock. The fund purchased Apple on April 17, 2014 at $74.99 per share. Let’s say today, Apple closes  at $113 per share. The funds current value, and the price you paid for the fund units, will reflect the value of Apple today at $113 per share. However, your basis for capital gain reporting purposes within your fund investment is the cost of Apple to the fund of $74.99 per share. Now let’s say the fund sells its Apple share tomorrow at the open at $113 per share. Your proportionate share of your fund in Apple will reflect a reportable a gain of $38.01 per prorated Apple share within your fund shares. This gain will be reported to you at the end of the year even though you invested in the mutual fund based on the value of Apple stock at $113. Worse yet, what if Apple fell to $105 per share and then the fund sold it. Your fund units will have proportionately declined for the drop in value of the Apple shares from $113 to $105, but, at the end of the year the fund will show a capital gain of $30.01 for the Apple stock and you will pay tax on that gain.

Now, funds have both embedded losses and gains as stated above, and again, probably more gains than losses. The question I raise is that wouldn’t you rather be in control of your investments and recognize gains on losses on your terms, whenever possible? Wouldn’t you prefer to have tax efficient investments? Certainly, there are circumstances that leave an investor with no alternative but to invest in mutual funds, such as most 401(K) plans, SIMPLE IRA plans and similar retirement plans; however, when possible, you may want to consider more tax efficient methods of investing.

At Joseph F. Fragnoli, CPA, PC in Nashville, TN, we perform formal and strategic tax and financial planning services utilizing sophisticated tax and financial planning software. We believe that the foundation for developing a successful and efficient financial plan begins with a “Tax Blueprint”. If you would like to learn a little more about our tax and financial planning services, please call us at (615) 678-4751.