Volatile markets and elections can lead to ulcers but can also provide a good dose of excitement. Fear and greed drive all markets and when things getting exciting, emotions can take over causing people to forget their long-term plan and jump into or out of the market. The emotional thrill of market gains is hard to deny. The losses can also be emotionally difficult. The IRS may be lurking in the corner in either case.
Large swings within the market have become more common than many of us are comfortable with. As investors see an increase in volatility, their natural reaction is fear, which can lead to emotional decisions being made within their investment accounts. The volatility causes panic which results in large withdraws from mutual funds by some investors. Managers of those funds then sell positions to meet the redemption requests. Confusion exists regarding mutual fund taxation. You can receive a 1099 tax form for gains inside of a mutual fund even if you didn't sell.
These gains are referred to as “phantom capital gains”. Phantom because you got taxed on gains even though you didn’t sell your shares. This is complex but occurs because you own units in a trust rather than the actual stocks inside the mutual fund. You create taxation by buying or selling your units. The mutual fund experiences taxation by selling the stocks inside the trust.
The manager purchased stock ABC in January for $25 a share. The stock appreciated to $40 per share. You purchased shares in June at $10 per unit. Now let's pretend there was sudden market volatility after you purchased your shares. Your investment falls to $8, but you don't sell. You have an unrealized loss on paper, though it is not a recognized loss since you didn't sell. However, some of your fellow investors did sell now the mutual fund has to raise cash.
ABC fell from $40 to $35, and the manager sold the shares to generate cash to cover the fleeing investors. The stock is less today than when you bought in, but because the fund bought the shares at $25 they have an internal gain. As an owner of the fund, you now get to recognize that gain on your tax return. Congrats!
This is important in volatile and questionable markets. Key turning points in the markets have witnessed erratic selling by mutual fund investors. Volatility often generates taxation as some investors will sell their shares and move to ‘safety.” Subsequently, they might receive a tax bill due the next April, but you could also receive a tax notice as well.
This does not impact your retirement accounts directly. After-tax accounts that are after-tax, investing in mutual funds during volatile times can lead to more than just excitement and frustration. Volatility can create TAXATION and sometimes phantom capital gains. Stick to your plan, but also understand your exposure to both risk and taxation.
Joseph A. Clark is a Certified Financial Planner and Managing Partner of The Financial Enhancement Group, an SEC Registered Investment Advisor. Joe can be reached at yourlifeafterwork.com or 800-928-4001. Securities offered through World Equity Group, Inc. Member FINRA/SIPC. Advisory services can be provided by the Financial Enhancement Group (FEG) or World Equity Group. FEG and World Equity Group are separately owned and operated.