Tax changes are in the news, with a seemingly endless string of proposals that could affect tax rates. If investment taxes don’t increase, it will not be for a lack of trying. Regardless of the outcome of political debates in Washington, D.C., very strong capital market returns since March 2020 will likely lead to material capital gain distributions across many investment offerings this year. For financial advisors, being in front of and ready for the potential tax impact of those distributions can help make the topic a productive part of your client engagement.
Are You Ready For Capital Gain Season?
Every fall, in addition to the trees losing their leaves, investors see stories about mutual funds distributing capital gains to taxable investors, including some that highlight a few outsized capital gain distributions. But beyond the outliers, the average distribution can be quite corrosive as well. Consider the last two calendar years: U.S. equity investors saw average distributions of 7% of the net asset value (NAV) across active and passive U.S. equity funds and ETFs.1 In dollars/cents, this means that an investor with $100 in a U.S. equity fund received, on average, a $7 distribution—even if reinvested. And that 7% was just the average, so we know many distributed much higher gains.
When you consider that the broad U.S. equity market was up 24%2 through October of this year, there is no reason to think the tax hit for 2021 will be any less harmful to investors. And it’s not just capital gains that erode return. Dividends (both qualified and non-qualified) and interest income can create taxable events.
How To Prepare?
The first step is to be aware of the potential return lost to taxes and after-tax returns across the product offerings in your practice. Many advisors don’t have access to after-tax analysis tools. At Russell Investments, we launched a Tax Impact Tool to help advisors analyze both after-tax and pretax returns in addition to the tax drag for almost all mutual funds and ETFs. The tool also shows ranking vs. Morningstar peers. For our tax-smart offerings, we post the after-tax returns daily for investors and post estimated capital gains monthly to make sure advisors have full information and no surprises.
Note that most mutual funds do not focus on after-tax returns. Given their original start was for 401(k) and IRA investors, taxes are typically an afterthought. Even municipal bond funds that have tax-free interest at the federal level can have meaningful return lost to taxes due to gains created through the buying and selling of the underlying bonds. This tax drag is even more critical in a year when many bond funds may be posting low single-digit or even negative returns.
Tax-Managed Equity Funds
Picking an equity fund that is tax-managed by definition opens the trading and implementation strategies that are geared to maximizing after-tax returns. These are strategies that non-tax-managed funds will not consider given they will not benefit the tax-advantaged accounts. It’s amazing how many investors treat both qualified and non-qualified accounts the same for evaluation and usage across their different accounts.
Example strategies available in tax-managed equity funds:
Active management: Take an active approach to stock selection through best-of-breed active money managers.
Centralized trading and implementation: By deploying multiple managers with different styles in a single fund and centralized within a single tax-managed fund, it affords better coordination in trading activities and greater efficiencies.
Tax-loss harvesting with full-year focus: A process that allows for a 24-hour trading desk to systematically target loss positions and offset taxable gains all year when market volatility presents itself. Loss harvesting at only year-end is suboptimal.
Wash-sale minimization: Laser focus to avoid—when appropriate—repurchase of stocks within 30 days that may disallow harvested losses.
Tax-smart turnover: Not all turnover is bad for taxable accounts. Careful evaluation of security trades is necessary to balance possible improvement in after-tax return vs. the possible impact of tax and trading costs.
Holding period management: A process to carefully monitor holding periods in order to ensure the differing tax rates on capital gains are considered. Funds that are not tax-managed will generally be indifferent between long-term and short-term gain recognition.
Yield management: Not all dividends are the same in the eyes of the IRS. The tax rate can be almost two times higher between qualified and non-qualified dividends.