Time For Cooler Weather, Falling Leaves, And—Capital Gains Distributions?
We are familiar with the adage, “Nothing is certain in life except death and taxes.” Your BFA investment committee understands that it is not what you save; it is what you keep. We have a system to minimize taxes in our client portfolios when possible. Our process includes reviewing tax efficiency when selecting our recommended investments, using asset location rules in portfolios, and assessing/minimizing our clients’ exposure to year-end capital gains distributions. (Mutual funds are required to distribute their realized capital gains by year-end.)
While it is important to never “let the tax tail wag the dog,” we consider an investment’s tax efficiency when we do our due diligence on our recommended securities. We review such statistics as the turnover ratio (the percentage of fund assets replaced in one year) and the tax cost ratio (how much taxes have consumed those percentages of investors’ assets over a trailing time period). We also consider the type of investment. For example, exchange-traded funds (ETFs), particularly those that index, are known for their tax-efficient structure, including not paying year-end capital gains distributions. Unfortunately, sometimes no suitable ETFs are available for our use in an asset class.
Asset location, or the decision of which securities should be placed in tax-deferred accounts and which in taxable accounts to maximize after-tax returns, is a crucial part of our strategy. For example, bonds and other fixed-income investments, which generate most of their returns in ordinary income, should be held in tax-deferred accounts.Now that fall has arrived, our focus turns to year-end capital gains distributions from mutual funds. Research from Russell Investments (see Figure 1) has shown market performance has no relationship to capital gains distributions, which can be short- and long-term. In fact, material (i.e., 5% or more of net asset value) capital gains distributions can happen in years when the stock market is down, which last occurred in 2022.
We review estimates of capital gains distributions as they become available and determine which are material. If it is a recommended fund, we can hold off on buying it until after the distribution. We can also sell those positions where it makes sense to recognize the built-up capital gains rather than take the distribution. Finally, we can do tax-loss harvesting, where we identify positions in taxable accounts that have a capital loss and swap out of those positions for 30 days. Capital losses offset capital gains and $3,000 of ordinary income in the current year and can be carried forward indefinitely for federal tax purposes.
While taxes may be inevitable, proactive planning and management can help make a significant difference. We stay committed to protecting your portfolio’s growth and helping to minimize undue tax liabilities year-round. Through thoughtful asset location, our selection process, and continually monitoring tax implications, we aim to help you navigate year-end capital gains distributions efficiently.
Explore how we address timely tax considerations using our ongoing True Planning Cycle. Please contact us anytime if you’d like to discuss your situation and needs more in-depth.