2022 was a tough year for investors. The S&P 500 was down almost 20% for the year while the bond market in the United States was down 13%, making it one of the worst years ever for bond investors. In fact, it was only the 3rd time that the stock market and the bond markets experienced negative returns in the same year. You’ll notice the title of this article is the Double Whammy. The negative returns are the first part of the whammy.
Adding Insult to Injury
Now it’s tax season. While the markets have recovered a bit since the end of 2022, you have been receiving your 1099s on your investment accounts. If you have taxable investments, you might be in for an unpleasant surprise. Even though your investments “lost” money in 2022, you might have to pay taxes on your investment accounts even though you lost money. Why would that happen? Here are a couple of explanations.
If you owned mutual funds, more than two-thirds of stock mutual funds made capital gains distributions last year. And even if you have your capital gains reinvested to buy more shares of the mutual fund, it is still a taxable event. In addition to this, when stock mutual funds pay dividends, those too can be taxable distributions thus, another taxable event.
If you own a bond mutual fund, similar things can happen. Most bond dividends are taxed as ordinary income and generate a tax bill. If your fund manager had to sell some of the holdings to satisfy redemption requests from other shareholders this could become a taxable event as well.
Basically, you lost money, and you have to pay taxes. That’s what I call the Double Whammy! What are you supposed to do?
Bad News/Good News
First the bad news. You can’t do anything about last year. You might be able to make an IRA contribution prior to your tax filing deadline to lower your taxable income for last year, but there’s nothing you can do to change the numbers on your 1099s.
Now the good news. There are strategies you can use to minimize some of these issues in future. Here are a couple of ideas you might consider.
Asset Location versus Asset Allocation
Most people have access to some kind of tax advantaged retirement accounts like a 401(k), an IRA, a Roth IRA or something similar. If you have taxable investments in addition to a tax advantaged account, it might make sense to keep more of the investments that generate taxable gains like bond funds and high dividend paying stock funds in your 401(k) or IRA and consider owning assets that don’t generate as much taxable income in your taxable accounts. You can still maintain a reasonable asset allocation, it’s just that you will have to look at your entire portfolio versus having a particular asset allocation in each account.
Tax Efficient Investments
There are other options available for your taxable accounts that are more tax efficient. These include, exchange traded funds or ETFs and index funds. An ETF is a fund that trades on an exchange and generally tracks a specific index. They are usually quite tax efficient because there is less trading than in an active mutual fund. In addition, investors buy and sell shares of the ETF on an exchange with other investors. The managers of the ETF don’t have to sell holdings to meet the redemption requests of other investors. Thus, avoiding the capital gain issues that we discussed earlier.
There are other options available for your taxable accounts as well. There are money managers and various funds that specialize in tax-efficient investing. Their goal is to not only grow your money, but to do it in the most tax efficient way possible.
There are also tax efficient bond investments as well. These include individual municipal bond as well as ETFs and mutual funds that invest in municipal bonds. Income from bonds issued by state, city and local governments is generally free from federal income taxes. You will have to report the income for state income taxes. However, a bond is generally free from state income tax in the state it was issued. If you live in New Mexico and you own a municipal bond from Colorado, it would be free from federal income tax but you would have to pay state income tax in New Mexico. If that same bond was issued in New Mexico, it would be free from state income tax as well.
While there are lots of options available to avoid the Double Whammy in the future, you have to plan ahead. Everybody’s situation is different. Some people can contribute to a Roth IRA while others cannot. Some people have a 401(k) plan available through their employers while others do not. It might make sense for you to max out your 401(k) but it might be best to keep more of their investments liquid for someone else.
If you got caught in the Double Whammy this year, it doesn’t mean it has to happen every year. Talk to your CPA or financial advisor about your personal situation. It’s called personal financial planning for a reason. If you want to talk to me, feel free to reach out to me HERE. As always, thanks for reading. KB