With Dec. 31 rapidly approaching, taxes are increasingly top-of-mind for both investors and financial advisors. The year 2015 is shaping up to be much like last year, which saw record-high capital gains distributions.
Both mutual funds and exchange-traded funds (ETFs) are required by law to distribute capital gains to shareholders, who then must pay taxes on those gains. In the case of long-term investments, that can mean up to 20 percent of capital gains go the federal government. Now is the time for investors to consult their financial advisors to find ways to minimize the potential impact of taxes.
Strategies For Managing Capital Gains
When faced with a potential capital gains tax obligation, investors and their financial advisors can sell loss-generating holdings to offset capital gains elsewhere in a portfolio. This is known as tax-loss harvesting.
But what if you don’t want to lose access to those holdings?
After the securities are sold, investors can then purchase similar, but different, securities to maintain the same type of industry, regional or factor exposure that was provided by the old securities. Here it’s important that investors not invoke a “wash sale,” as defined by the Internal Revenue Service. A wash sale involves selling a security for a loss, while purchasing a “substantially identical” security to replace it 30 days prior to or after the sale. Because IRS rules involving wash sales can be somewhat nebulous, it’s important to consult a tax professional when engaging in tax-loss harvesting.
Alternatively (and after consulting an advisor), investors could replace their loss-generating holdings with an ETF that offers similar industry, regional or factor exposure. ETFs are a natural replacement candidate for tax-loss harvesting strategies for two reasons:
• They have a tax-efficient structure. When an authorized participant wishes to redeem shares of an ETF, an ETF provider can simply deliver the underlying holdings of that particular ETF, rather than selling ETF shares and triggering a taxable event. Importantly, in-kind exchanges generate no capital gains—one of the primary reasons that ETFs are so tax efficient. In fact, every year only a small percentage of ETFs distribute capital gains.
• A wide variety of ETFs are available targeting different industries, sectors, global regions and investment factors. Because of this range of choice, investors and their advisors can use these tools to potentially fill in any portfolio gaps created when selling securities.
Foreign Exchange As A Tax Risk
International investing adds another wrinkle to the tax conundrum. Although international securities can generate strong returns, these gains can be offset by unfavorable currency exchange rates. Consider Europe as an example: Through October, the EUR/USD (euro to U.S. dollar) exchange rate has depreciated 12.1 percent in 2015, meaning that stocks denominated in euros were worth less in U.S. dollars at the end of October than they were at the beginning of the year. Without a hedge in place, this could leave U.S. investors facing significant losses on their European holdings—even if the stocks themselves posted gains. Conversely, I believe a strategy that hedges European equities to the U.S. dollar is more likely to have resulted in capital gains—and a tax burden to match.
Being prepared about tax strategies as the year comes to an end, can add value to your portfolio in 2016 and beyond.
John Feyerer is vice president and director of Equity ETF Product Strategy at Invesco PowerShares.