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.
Who Wants A Loss? Investors Want Stocks That Go Up / Not
Down
In meeting with advisors and investors over the years about
these tax-smart investment strategies, there is often pushback about tax loss
harvesting. Investors want their stocks to go up—not down. Recall that loss
harvesting is the act of selling a stock that is lower in price than its
original purchase price on an adjusted-cost basis. This difference can be a
loss that is harvested and used today or in the future to offset realized
gains. This loss is considered a tax asset and may help in deferring the
recognition of gains (if you have them) until later periods. Importantly,
within a mutual fund, these realized losses do not expire. Done correctly, this
deferral of gain recognition is intended to both increase after-tax returns and
help maximize after-tax wealth.
Speaking about broad market returns for the more popular
indexes like the S&P 500 or the Dow Jones Industrial Average often masks
what happens within the equity market. Consider last year when the S&P 500
Index was up 18.4%. This very attractive double-digit annual return likely gave
investors the impression everything must have been up.
Looking at actual constituent returns reveals a fuller
story. Exhibit 1 shows the range of returns across the index for the year. The
exhibit is sorted by market capitalization size left to right. For the year,
there were just over 300 stocks with positive returns and 191 names with
negative returns. It takes all ~500 names and market capitalizations to equal
the total return of 18.4%.
An active tax-managed approach provides a process to
capitalize on these return disparities. And one cannot assume that a stock that
was positive for the full year was positive throughout the full year. An active
approach allows for an analytical, systematic framework to understand the costs
to include—trading costs, tax costs, tracking error and more. These trades
can’t be done just to avoid a tax. Having a 0% return and $0 tax bill is not a
path to successful attractive after-tax outcomes. Professionals can perform
this analysis on every trade throughout the year.
Helping Investors
Whether tax rates change or not, we know taxable
distributions from capital gains and income erode an investor’s return. Many
investors are not taking these tax headwinds into account when making their
investment-selection and asset-location decisions. Making informed decisions on
tax-managed offerings can make a meaningful difference for client investment
outcomes.
1. 7% distribution based on Morningstar broad category “U.S.
Equity,” which includes mutual funds and ETFs (and multiple share classes). % =
Calendar Year Cap Gain Distributions/Yr-End NAV. Includes all share classes. 2.
S&P 500 Index.
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