Key Takeaways
Fund managers are legally required to distribute to shareholders all of the income and net capital gains they’ve realized for the year.
Asset location can help you consolidate your taxable accounts and qualified accounts so you can make the most tax-advantaged investments for each.
Consider index funds and other passively managed funds. With lower turnover, they tend to distribute much less in capital gains to shareholders.
Start planning now for year-end distributions from your funds. Don’t wait until tax time next spring.
Now is the time of year that many investors start looking for assets they can sell to raise cash, to harvest losses, to take some chips off the table, or maybe just to get out ahead of the (likely) higher capital gains rates in 2022. While these decisions are not always easy to make, you, the investor, are in control of when you realize gains (or losses) through the sale of your investments and how much from that transaction you realize.
But there’s another type of capital gains you can’t easily anticipate or control, and it’s often a rude surprise come tax time. I’m talking about internally-generated dividends and capital gains distributions from the mutual funds, closed end funds, real estate investment trusts (REITS), and less often ETFs that you own in your taxable accounts.
By law, fund managers must distribute 90% of their dividend income and 98% of their net capital gains to shareholders each year. They may also have to sell holdings in response to huge inflows or outflows of investor money into their portfolios. The problem is they don’t consult with you—the shareholders—about those decisions. They just do it – and you’re left holding the tax bag for their decisions.
It’s kind of how I feel after I’ve been raking and bagging leaves all afternoon—only to have my neighbor’s unraked leaf pile blow onto my lawn an hour later. I can’t control the direction of the wind, but I can control how I deal with its impact on my lawn. Same goes for those internal, aka “ghost” distributions sent to you from the funds you own.
For more about why funds pay distributions now, see Why Mutual Funds Pay December Dividends: An Introduction to Excise Taxation.
What can smart investors you do about year-end fund distributions?
Start planning ahead in November and December. While you may not receive your fund’s Form 1099-DIV until a month or two before the April 15th tax deadline, you can get a good estimate now of what your funds will be paying at tax time. Publicly available sites such as CapGainsValet track the capital gains and dividends declared by most of the major funds. There’s even a list of funds in the “Doghouse” that plan to distribute a whopping 20% to 40% of their NAV to shareholders in the form of taxable capital gains. Ouch!
Pay attention to ex-dividend and record dates
The record date, is the cut-off date that a company uses to determine which shareholders will receive a dividend or distribution. The ex-dividend date is set exactly one business day before the dividend record date. On and after the ex-dividend date, a buyer of a stock or fund will not receive the dividend since the seller is entitled to it. For those not aware, this is not a bonus. The value of your holding (mutual fund) goes down by the exact amount of the distribution. Don’t hold on to the investment because you think you will miss out on a payment owed to you as a shareholder.
That’s why we review all of clients’ holdings for opportunities or issues like these. We compare the estimated distribution against the gain or loss in the asset. If the estimated distribution is larger, we will typically sell the position and buy an alternate asset until the record date has passed. It can be a complicated process, but it’s financially worthwhile to avoid distributions. We’ll talk about this strategy in more detail in my next post.
NOTE: According to the “wash sale rules,” if your position was at a loss, you cannot just sit out on the record date and buy back in to that same investment a few days later. You must stay out of that position for at least 30 consecutive days before buying back in. Otherwise, you will not be able to claim a loss for tax purposes. You can purchase a similar asset, but it cannot be substantially similar.
Consider ETFs and passively managed mutual funds
Going forward, try to buy index mutual funds or ETFs instead of active mutual funds. Given the lower turnover of index funds, you're less likely to have the manager make gains-realizing sales. Also, ETFs add an even greater degree of protection, since investor redemptions don't create a need for asset sales. (NOTE: ETF units can be created or destroyed based on investor demand.)
ETFs have internal controls that allow them to minimize the need for distributions. There are also tax advantaged mutual funds whose mandate is to actively monitor and managing the tax consequences that their shareholders will endure at the end of the year.
Asset location
By owning a mix of taxable accounts and qualified accounts (i.e., IRAs, 401(k)s or SEPs), we can manage them as though they are all in a large single account. Let’s say you have $1 million spread out evenly between an IRA ($500,000) and a taxable account ($500,000). Most people manage the two accounts individually without taking into consideration the tax consequences. But if you treat the two $500,000 accounts as a single $1 million account, there are opportunities for substantial tax savings.
For instance, you would use the IRA to invest in assets that are likely to pay higher dividends on an annual basis, such as REITs, lower-quality corporate bonds, international bonds or emerging market stocks. These holdings have high upside potential, but also higher volatility or more turnover--and thus, higher potential taxes. Again, the tax-impact is not as important since these are in tax-deferred accounts. Meanwhile, you fill up your taxable account with holdings that have higher growth (i.e., capital appreciation) potential, but lower turnover. Thus, they’re less likely to throw of dividends or distributions--think U.S. growth stocks, developed market stocks, or municipal bonds. All tend to have lower yields and thus, lower tax consequences for the investor.
Conclusion
These strategies above have been especially helpful for our clients who are retiring between the ages of 55 and 72. They’re in the prime age for incorporate tax planning into cash flow planning to reduce their tax bill and improve their total outcome. Please contact us any time to discuss in more detail. We’re happy to help.
By ROBERT B. DUNN, CFP® President and Managing Partner of Novi Wealth