2018 – A Year of Tax in the Face of Volatility
It is the most wonderful time of year! At least that’s how it’s supposed to be. But with stock market woes piling up in December, that statement definitely doesn’t apply to finances. To make market matters worse, an inefficient tax portfolio could be kicking you while you’re down, especially in 2018. In the closing weeks of the year many funds go through a process called Capital Gain Distributions. This occurs when a fund liquidates underlying holdings, and the tax effect is essentially distributed across owners of the fund.
You own a fund worth $100. It will pay a capital gain distribution of $10 (10% distribution) per share.
On the record date – the company determines if you are eligible to receive the distribution.
On the ex-dividend date – the price of your share drops by the distribution amount, to $90.
On the pay date (the next day) – you get the $10 of cash.
As you can see, if you add both numbers together you still have $100. But now, $10 is in the form of cash. Further, if you own that fund in a taxable account, you pay tax on that $10. Essentially all this does is increase your tax bill!
It was relatively easy to ignore capital gain distributions in 2016 and 2017 when investors experienced less volatility and large returns. However, 2018 offers a different story as many investors have experienced volatility more in line with historical averages along with some negative returns across various asset classes.
Some of the largest distributions this year come from actively managed mutual funds which incurred gains from a run up over the past decade in addition to investors continuing to transition away from active to passive funds. Below are some of the largest distribution estimates for 2018 and their performance year-to-date (through 12/20/2018):
With this unfortunate news what is an investor to do? We often tell our clients to only worry about the things they can control. Well, we can help control taxes with effective Asset Placement and Capital Gain Distribution Avoidance:
This is the practice of placing “Tax Ugly” assets into qualified accounts. For example, certain asset classes tend to spit off large dividends and interest throughout the year and have larger distributions at year end. When this is the case opting to place this into a tax-sheltered account can reduce a client’s tax drag.
Capital Gain Distribution Avoidance
As a firm we look at all client’s holdings to understand what their unrealized gain in the position vs the estimated capital gain distribution. If the distribution is larger than the gain, we can opt to sell the position before the Record Date and in some cases sell at a loss which helps offset other gains. By doing so, the client’s tax return will not see the impact of the distribution.
As we are mindful of our portfolio construction and implementation it could make sense for clients with outside accounts to have a tax efficiency checkup, and we’d be happy to help. As always, please contact your team if you have any questions.