Understanding Phantom Income (and its scary tax implications!)

Peter, good to see you.

Welcome back, everyone. Today we have phantom income. We're going to talk it through and talk through its very scary tax implications. Few things sound scarier than phantom income, and you'd think any kind of income would be good, but this one and the taxes that come with it can take a lot of investors by surprise.

So Peter, Peter, again, let's just start at the top. What is phantom income? It's income that you may not have intended to take or create.

And in fact, the phantom part of it is that you didn't even take it in most cases. It's income that is created within a mutual fund investment and specifically in a non-qualified, non-retirement kind of account. So we've got a couple of different levels there. You've got the kind of account that you are investing in, and then you've got the actual investment vehicle that you are holding within the account. So if this is a non-retirement account and you are holding mutual funds within it, that mutual fund is a collection of individual stocks. And the mutual fund manager throughout the year may buy, sell, and trade those stocks within the mutual fund. That creates a taxable event that is passed along to the investors. So mutual funds, I call them socialism in investment form.

And I say that because they abide by the from all according to their ability to all according to their needs. If I invest in a mutual fund with $10,000 and somebody else invests in the same fund with $10 million, we both pay the same internal expense ratio. But if we both were to have invested the same amount and then the fund goes down in value and I want my money back out, or the fund manager decides to trade and sell some funds within it, that gain that is realized when the internal holdings are sold actually get passed along to every investor.

So number one, phantom income could be from internal turnover. And if you look at a mutual funds kind of backend ratings and stats, a lot of mutual funds have a pretty high turnover. They tell us to buy and hold and don't sell for long-term success. But inside of mutual funds, a lot of times they are doing the exact opposite. I've seen mutual funds with turnover ratios as much as 200 to 400%, meaning every holding in the fund was sold and bought at least two to four times within the year. Now I've seen some that are maybe a little bit more reasonable that only have a 20 to 40% turnover ratio, but almost every fund inside of them is not just buying and holding and holding forever. They have some manager that is making some investment decisions.

After all, that's what you buy a mutual fund for, to have a little guidance in your investment. But those transactions inside of the mutual fund can create gains that are passed along to every investor. And Aaron, what surprises a lot of people is that can actually happen in years where you on paper lose money inside the fund itself. So 2007 and 2008, we had that big market downturn, the great recession, and a lot of people lost a lot of money in their mutual fund investment accounts. And then they got a notice that they owed taxes on that. That's because that there were some transactions inside of the mutual fund that actually created some gains.

And that happened again in different periods, 2022, probably the most recent one where people lost a great deal of money in both their stock mutual funds and their bond mutual funds, by the way. And then in 2023, before they filed taxes, they got this notice that, hey, yeah, you lost money in your mutual fund investment account, but by the way, you also owe taxes on that loss. And that's why phantom income is so scary. So just to underscore this, then you could be paying taxes when you've had a loss and you could be paying taxes on money you never even received.

Yep. And again, that's why phantom income is so scary and why it catches a lot of investors by surprise there. You know, a lot of people are like, well, I didn't take any income, so therefore I don't owe any taxes. That depends on the kind of account you're invested in. And then a lot of people are like, well, I lost money, so obviously I wouldn't owe any taxes. And that depends on the internal funds that the manager of that, that mutual fund bought and sold and transacted within the tax year. So yes, you are offloading some of the investment choice and decision and actual hands on management, hopefully to a fund that has a good track record of growth over time.

But you are also trading off some of the responsibility. Yes, but the responsibility for both the management and the realization of when those taxable events occur within the fund, which don't hand off the responsibility of paying the tax on those transactions. So how will I know that I'm paying the tax that I'm responsible for it? Am I looking for that on my tax return somewhere? Yeah, well, you'll file it on your tax return.

You will get a tax form for that. So, yeah, the investment account, the institution that holds your non-qualified investment account will every year issue a tax form that basically tells you the gains or losses that you are responsible for. And most of the time people have several different mutual funds or a collection of investments within a specific account.

They'll all sort of be aggregated. But if you've got one account and you're looking at it with one mutual fund in it, you may see that this mutual fund, even though you didn't take anything out of it, created this phantom gain or that it lost value and you actually have a positive taxable event. So that, again, we don't want anybody to be surprised.

So we try to explain this. And this is also particularly of interest if you do transfer or move accounts. You've got to be sure to understand the tax implications there as well. It doesn't necessarily have to create a tax implication. If you do it the right way through ACAT, moving an account could just retain the same holdings. But if you say, well, these aren't the right holdings for me, let's change or rebalance what I'm holding inside the account. You really need to look at the cost basis of that because it is a separate kind of issue here. That's a capital gain rather than phantom income.

But that's something that catches people by surprise as well. And I know you focus on strategic tax planning. So how do we avoid phantom income? Well, there are certain types of investments that are subject to phantom income where there may be alternatives that basically do the same thing that are not. So mutual funds were designed to allow investors some diversification within a single investment. And the way that I give the analogy for that is that betting on one horse in a horse race is kind of like buying a single stock. The payoff could be very high, but the risk also may be pretty substantial. Mutual funds were designed more to say, hey, most of these horses are going to finish this race eventually. So the risk is much less, but the reward may be a little less as well. But that's diversification. And that's what a lot of people need because that's a fundamental of long-term investment success, that you don't bet at all on one thing where it's success or failure. You place your bets, so to say, you make your investments across a broad range and you have a better likelihood of consistent outcome. Well, the mutual funds have this phantom gain potential, phantom income, whereas maybe what is another alternative, kind of a newer iteration, and it's not so new anymore, but ETFs, exchange traded funds, have the same premise. Exchange traded funds allow an investor to have a broad range of investment holdings, maybe an entire sector, maybe the entire market, without having the phantom income created within the fund. So where you were looking for diversification and a single investment in a mutual fund, in a non-qualified account, you may want to instead consider ETFs, both because they avoid the possibility and the potential for phantom income, and because generally they are a little less expensive. Their internal costs are lower in general and a difference in a half to 1% in fees also makes a difference over time.

Other than picking ETFs instead of mutual funds, are there any other strategies to avoid phantom income? Sure. Yeah. If you are investing, it needs to be a long-term kind of mentality, right? Is that when you invest in the market, you should theoretically say, I don't need that money for at least five to 10 years, or maybe much, much longer, because we don't know where the market is going to be next year, right? There are signs, there are indicators, there are trends, but we have no guarantee where it's going to be next year. Over time, the market should go higher. It always has trended higher over time, but in any given time, we don't know. Investing is long-term.

Let me premise this statement with that. However, a lot of people now are more active in their trading. With technology, it has allowed us to have access to these financial institutions where we can execute trades much quicker, and in fact, day trading is available to the average investor now. Here's the caution and the alternative, that if you are making trades and transactions that are not long-term, that you do not intend to be in for at least a year and a day, if not longer, if you are executing trades on a regular basis, rebalancing your account, or even day trading, you should consider doing that inside of a qualified account rather than a non-qualified account. A qualified account means qualified for certain tax advantages. Retirement accounts, your IRA or your Roth IRA, trades and transactions within the account don't equate to an immediate taxable event because those are tax deferred until retirement. All exchanges, all trades, all transactions inside of an IRA or a Roth, including the phantom gains or the capital gains kind of trade and transaction events just are part of the protection of the tax qualification and therefore don't generate a taxable event. So short story long here, if you are trading and transacting on a regular basis or a short-term basis, you may want to consider doing that inside of an IRA or a Roth, and that way you don't encounter phantom gains or capital gains.

And if you have a non-qualified, non-retirement account, you may want to consider ETFs compared to or opposed to mutual funds. Well, I'm really glad we got to talk this through, especially ahead of Halloween. I don't know how we would do that as a costume, Peter.

Yeah. It's a spooky time of year. We're talking about a spooky subject here with phantom gains. There are also vehicles, Erin, that can take non-qualified money and then just defer the taxes on them without the trades and costs and transactions.

You may be looking at, again, a little longer timeframe, but there are annuity options fixed or fixed index that can give you growth without the capital gains or the phantom income risks. And yes, it's spooky, especially when you get hit by it and you didn't expect it. So that's why we want to bring it to people's attention. Exactly. So Peter, if somebody would like to talk through some of these strategies, then what's the best way to reach you? Give me a call.

9 1 9 3 0 0 5 8 8 6 9 1 9 3 0 0 5 8 8 6. And if you've experienced phantom income or if you've got just a brokerage account and investment account, that's got a lot of mutual funds in it and you're wondering why you have seen tax forms from that. Let's let's certainly review your allocation because there may be alternatives to unwind and avoid that into the future.

Would love to help you take a look at that. And again, one of one of our guiding principles is that our clients should understand what they are invested in, including the tax implications that is ultimately going to affect your return. It's not what you make. It's what you get to keep. Taxes are important.

You should understand the potential tax implications. It's something that we stress and emphasize and go over with our clients. So give me a call.

9 1 9 3 0 0 5 8 8 6. We do a complimentary review. We'll put together that optimized retirement plan for you. You can also get in touch, email or online. It looks like rich on planning dot com is the website. And Peter at Rashan, planning dot com is the email. All right, Peter, thanks for your time today. Always a pleasure.

And thank you. Hey, folks, Peter Rashan here with Rashan planning. So glad that you are enjoying the podcast Planning Matters Radio. You know, one of the tools that we've put out there that people really seem to appreciate and really are our finding of value is at nine one nine retired dot com. It is your retirement tax bill calculator. If you've got any kind of retirement account, your tax deferred 401K or IRA, this is the website.

This is the resource where you can go. You can plug in your own numbers, your information. You can slide the tool calculator up and down for your tax rate or your amount of savings and see what your tax bill is likely to be if you default and defer to the IRS's plan versus what you could potentially bring that tax bill down to. A lot of times it is a very significant saving.

So if you have not yet, go to the website nine one nine retired dot com. Run your numbers on the retirement tax bill calculator. This has been Planning Matters Radio. The content of this radio show is provided for informational purposes only and is not a solicitation or recommendation of any investment strategy. You are encouraged to take investment tax or legal advice from an independent professional advisor. Any investment and or investment strategies mentioned involve risk, including the possible loss of principal advisory services offered through Brooke's own capital management, a registered investment advisor, fiduciary duty extends solely to investment advisory advice and does not extend to other activities such as insurance or broker dealer services. Advisory clients are charged a quarterly fee for assets under management while insurance products pay a commission, which may result in a conflict of interest regarding compensation.