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  • Writer's picture Treavor Dodsworth CFP®, CPA, CKA®

#159 - Why You May Have Taxable Investment Income in a Down Year

Why You May Have Taxable Investment Income in a Down Year

Many of you with taxable brokerage accounts (not retirement accounts like IRA, Roth, SEP, 401k, etc.), will receive a tax form called 1099-DIV in the next couple of months. You may be surprised to find that in a year when many investments went down that you actually have taxable investment income to report.

This is one of the confusing aspects of investing that I am going to attempt to simplify. ETFs and Mutual Funds may push out income in a year via dividends or capital gain distributions. Many individuals have these payments set up to automatically reinvest in the same security therefore some investors don't even know they are happening. Even if you never received them in your checking account though, they can still be taxable investment income.

This income is generated for a few reasons. In the case of a mutual fund, the fund owns many (potentially thousands) of stocks. They may have owned a stock within the mutual fund for the last ten years and it has gone from $1 to $100 in 2021 to $90 in 2022. Even though the stock decreased in price in 2022, if the mutual fund sells that stock in 2022, they are generating income of $89 ($90-$1). Generally speaking that income eventually gets passed on to you the individual investor.

This is primarily a timing issue as income that is pushed out raises your basis. Therefore if you are in the exact same tax situation and the rules are the exact same this year and whenever you subsequently sell the stock what you are primarily missing out on is the time value of money of the tax you have to pay on the investment income. This isn't always the case though. For example, you may be in a 0% capital gains bracket in the future or you may have given the long-term investment to charity. In these cases, it is possible you would never have had to pay federal tax on that income had it been generated in the future as opposed to today.

One of the interesting things is you don’t have to own the mutual fund for the full time it owns the underlying stock in order for the income to be generated. If a fund is paying a 15% distribution and you own $1,000,000 by the distribution record date, you will likely end up with $150K of income to factor into your tax planning.

Now, many of you may be thinking, wait isn't income a good thing? I would gladly pay tax on the $150K if it meant I received an additional $150K. This isn't the way it works. The value of your mutual fund holdings adjusts for the fact that the income is paid out so just because the fund paid a distribution of $150K, doesn't mean that your account balance went up $150K. That is one of the primary reasons these distributions are confusing.

Just because your account balance has gone down this year doesn’t mean you won’t have investment income to report.

  • "My only take on the pundit class and their forecasts is the consensus will likely be wrong. What most people think will happen in 2023 probably won’t happen."


Thank you for reading!

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