A clever little term is being bantered about on social media this tax season to describe how tax preparers might break the bad news to clients: Congratudolences.
It’s a word you might offer, according to the Urban Dictionary, to a co-worker who has accepted a job promotion that is a mixed blessing. Say something that moves her up the ranks but clearly puts her in more direct contact with a cantankerous colleague.
Congratulations on your success. Condolences for what’s ahead.
“Congratudolunces.”
“I think I’m going to use it with clients that have to pay a big tax bill because they made a lot of money,” enrolled agent Matthew Cordes said in a lighthearted Tweet.
Eye-popping numbers for taxable income are being put in front of investors and others who saw financial success in 2021, often for triggering tax scenarios and tax bills that many never imagined.
A million-dollar moment triggers big tax headache
Blame Bitcoin and virtual currency. Blame lots of trading in stocks. And yes, blame mutual funds that paid out some extraordinary capital gains distributions after a robust rally on Wall Street last year.
The Standard & Poor’s 500 rose nearly 26.9% in 2021. The Dow Jones Industrial Average climbed 18.73% in 2021. And your tax bill?
Big gains can mean big money at tax time.
James O’Rilley told me of one investor who made well over a million dollars buying and selling virtual currency almost daily last year.
The man — a friend of a friend who wasn’t aware of all the tax ramifications — ended up being shocked by the outcome, according to O’Rilley, a CPA and tax director for Doeren Mayhew in Troy.
He had taken an early retirement — or so he thought, O’Rilley said — but then owed more than $400,000 in federal taxes for 2021 on his virtual currency gains.
The gain of more than $1 million last year amounted to short-term profits that are taxed at regular income tax rates. In this case, the money was taxed at the top rate of 37% plus a “net investment income tax” of 3.8%.
“The problem is the value of the portfolio dropped substantially in 2022 to a level where he needs to sell the entire portfolio just to pay the taxes,” O’Rilley said.
One small plus side to this story: The investor lives outside of Michigan and in Florida, which does not have a state income tax. Even more money would have been owed on the state level if the man who bet on Bitcoin lived where there is a state income tax.
Mutual fund investors get clobbered by unusual capital gains
One didn’t need to be a day trader, though, to face tax headaches. Even passive investors saw incredible tax troubles.
One reader told me that he has been investing money in mutual funds for about 30 years and doesn’t remember anything like this happening.
For 2021, his capital gains distributions from his mutual funds outside of tax-deferred retirement accounts increased by shocking $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 who live in the Traverse City area saw their federal and state of Michigan tax burden go up by $20,000 this tax season.
Fortunately, the couple — who asked not to be named because they didn’t want others to read about their finances — was able to pay and did not have to borrow money to cover the taxes due.
Cordes, who prepares about 650 individual returns a year, told me about one elderly client who normally would have to report about $5,000 to $8,000 in taxable capital gains distributions from mutual funds held outside of tax-deferred retirement accounts.
This year, the client had to report $55,000 in taxable capital gains distributions.
“His tax due this April 18 is over $11,000.”
Cordes has heard of clients elsewhere facing even bigger 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 do not realize that mutual funds must distribute the 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 payout,” he said.
What you’d get is a 1099-DIV to report those capital gains distributions from mutual funds. Typically, those are sent out in late January.
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Good rally shares some of the blame
The strong rebound in the stock market in the second half of 2020 after the meltdown at the start of the pandemic and sizable gains last year resulted in larger distributions than normal for many funds, according to Fidelity Investments.
“Periods of extended rising equity markets will naturally result in higher distributions since fund managers are less likely to have losses to offset gains,” according to a Fidelity spokesperson.
About 53% of the mutual funds based in the United States, including exchange traded funds, reported capital gains distributions for 2021. That was up from 43.1% in 2020, according to Chicago-based Morningstar Direct, a research firm.
Morningstar noted that 5,405 mutual funds reported capital gains in 2021, compared with 4,234 in 2020.
How many funds pay out such distributions vary year to year. Based on Morningstar Direct data going back to 1990, spikes where 60% or so of mutual funds had capital gains distributions were relatively rare and took place in 1993, 1997, 1998, and 2007.
During that time, we saw four years — 2002 and 2003, as well as 2009 and 2010 — when only 25% or fewer funds had such distributions.
The dollar amount of the distributions, though, can shock investors who have been saving a great deal 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 easy math example. If you had $10,000 in a mutual fund outside of a retirement account, you’d have an extra $1,000 in taxable capital gains income when a fund has a 10% capital gains distribution.
Many investors over the years have built up quite a bit of savings in taxable mutual funds held outside of retirement accounts. In those cases, you’re looking at taxable income when a mutual fund has a capital gains distribution.
For many retirement savers with 401(k)s and IRAs, it’s a non-event if the mutual fund is in a tax-sheltered account. You’re getting hit with taxes when you begin 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 based on the investment strategies of the mutual fund.
For the taxpayer, a short-term distribution would be taxed at the individual’s ordinary income tax rate. There are seven income tax rates in place 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 would distribute short-term gains. As a result, investors may find it more advantageous to hold funds with a higher turnover rate in tax-shelters accounts, such as traditional IRAs and Roth IRAs, according to Fidelity.
Taxpayers receive a break on long-term distributions. The long-term capital gains tax rates are 0%, 15% and 20%, depending on your income.
Mutual fund companies began publishing estimates last November of the capital gains distributions that were likely to be made in mid-December. But funds may pay distributions throughout a year.
These “off-cycle” distributions may be the result of a fund merger or investment mandate change, according to Fidelity.
Growth funds again made significant distributions, but in 2021 value strategies gained popularity and made some make some big 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 basis 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 anticipated, owing to all the cost-basis step-ups that the regular distributions triggered,” the experts wrote in a capital gains round-up in late November.
After this year’s surprises, though, many investors will no doubt pay more attention to the risk of a potential tax surprise if you’re holding an actively traded mutual fund outside of a tax-deferred retirement account.
Contact Susan Tompor via stompor@freepress.com. Follow her on Twitter @tompor. To subscribe, please go to freep.com/specialoffer. Read more on business and sign up for our business newsletter.