A Real Client Example: When a Mutual Fund Created an Unexpected Tax Problem
We recently worked with a client who owned mutual funds in a non-retirement brokerage account. The investments themselves weren’t necessarily the problem. The issue was that the funds were distributing capital gains each year and created taxable income even though the client wasn’t personally choosing to sell the investments.
A Real Life Example
This client had accumulated mutual funds in a taxable brokerage account over the years. Since this was a non-retirement account, taxes mattered. They had a portfolio where they bought and held mutual funds didnt sell a share and still got a capital gain distribution that needs to be accounted for on their tax return.
This was important for this family because we were also evaluating Roth conversions.
How It Affected Our Roth Conversion Analysis
For this client, we were looking at whether converting a portion of a Traditional IRA to a Roth IRA made sense.
A Roth conversion creates taxable income in the year of the conversion, so we don’t look at the conversion by itself. We want to understand the client’s entire tax picture such as income, deductions, realized gains and losses, and other factors that could affect the analysis.
The mutual fund’s capital gain distribution became another variable we had to consider. Adding additional income and pushing the client to another tax bracket can be a very costly mistake.
It didn’t mean that we shouldn’t complete a Roth conversion. It meant that we needed to account for the additional taxable income when deciding how much we wanted to convert that year.
This is a great example of why I don’t believe investment management and financial planning should be treated as two completely separate things.
Why We Didn’t Just Sell the Mutual Funds
Once we identified the issue, the easy answer might sound like: sell the mutual funds and buy ETFs instead.
But financial planning usually isn’t that simple.
The client already had unrealized gains in some of the mutual fund positions. Selling everything immediately could have created a significant taxable gain of its own. Possibly Capital Gains Tax Plus Net Investment Income Tax at a minimum
We didn’t want to solve one tax issue by unnecessarily creating another one. So we developed a multi-year approach. Over the course of the past few years, we gradually transitioned portions of the portfolio from mutual funds into ETFs.
Each year, we could evaluate the client’s tax situation, realized gains and losses, income, Roth conversion opportunities, and the rest of the financial plan before determining how much of the portfolio made sense to transition.
By taking our time, we were able to be much more thoughtful about the tax impact rather than making one large change all at once. While every client’s situation is different, a coordinated, multi-year transition could meaningfully reduce unnecessary tax drag compared to an immediate, all-at-once approach.
B Riley Wealth Management, Inc. and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.
Certain services require collaboration with unaffiliated third parties. Holistiplan is not affiliated with Opes Private Wealth Management, Eisner Wealth Management, B. Riley Wealth Management, or any of its subsidiaries. The client example is provided for illustrative purposes only and provided by a current client who was not compensated for their participation in this article. Client experiences described above may not be representative of the experience of other clients and are not a guarantee of future performance or results. Individual circumstances and results may vary
ETFs and Mutual Funds involve risk, including the possible loss of principal. The suitability of any investment depends on each investor’s individual circumstances, goals, and risk tolerance