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Advisor Insights

Advisors, Help Your Clients Avoid This Nasty Year-End Tax Surprise

Capital gains distributions are coming, but clients can avoid them.

The markets are wild. Clients are not happy seeing their nest eggs depleted. As we approach year-end, advisors have an opportunity to play hero—or they could do nothing and wait for complaints. Here’s how to turn a potential disaster into a moment to shine.

And for more insights on tax strategies to use in the down market, sign up for our webinar.

The Potential Disaster: Capital Gains Distributions

What could be worse than portfolio values dropping? How about topping that with paying taxes on phantom income? Your clients lose money and must pay taxes! Try to explain that! OK, I will.

When there is volatility in the markets, mutual funds tend to experience a higher level of redemptions. To create cash for the redemptions, funds need to sell positions, and these sales can still create capital gains—even in a down market. The capital gains are passed through as taxable income to the remaining fundowners even though they received no cash. That’s phantom income, otherwise known as “adding insult to injury.”

From a quick survey of a few major fund companies, it’s clear that capital gains distributions can be quite material this year. For example, some American Funds offerings are estimating year-end distributions as high as a range of 6% to 9% of net asset value. JP Morgan estimates go as high as 12% to 23% of NAV for some funds. BNY Mellon has issued estimates for some funds to be 12% to 17%. T. Rowe Price estimated year-end distributions of 10% to more than 20% of NAV for some funds. You get the idea. Clients won’t want to experience this unwanted surprise.

How Can You Help Clients Avoid Capital Gains Distributions?

To avoid these distributions, clients can sell out of high-distributing funds before the posting date. Most posting dates are mid-December, so there is still time. Check out estimated distributions for your clients’ funds. You can search by individual fund companies or use a resource like Cap Gains Valet.

Once you’ve identified the problem funds, you’ll need to find alternative positions with lower distributions, so your clients will continue to be fully invested in the interim. Investing in a similar position that has little to no estimated distributions will enable clients to maintain their investment strategies while avoiding the phantom income. For example, if ABC Small-Cap Fund is estimated to distribute 10% of NAV on Dec. 18, you might want to sell it and purchase DEF Small-Cap Fund, which is estimating capital gains distributions of only 1%. Be sure that you feel comfortable holding the substitute position for the long term should it appreciate in the interim. If there is no acceptable replacement position, it is generally not advisable to sell the high-distributing fund solely to avoid a capital gains distribution.

Finally, you need to consider the tax consequences from selling positions. If selling a high-distributing fund will result in a loss, the client will realize two benefits: avoided tax on distributions and lower capital gains tax from the recognized loss. However, if the sale of the high-distributing fund will generate a gain, it will offset the benefit of avoiding the distributions—possibly even producing a net cost to the client.

What If You Don’t Have Software to Help?

Unless you are using software (such as Morningstar Total Rebalance Expert), avoiding capital gains distributions can be a lot of work—especially if you attempt to run calculations for every position held by every client. My recommendation: Limit your calculations solely to clients who hold a material amount of funds with disproportionately high distributions.

What is material? This must be considered both on a dollar and percentage standpoint. Typically, advisors will not bother with capital gains distribution avoidance unless potential tax savings are at least $500 to $1,000. At a capital gains tax rate of 20%, this equates to a minimum distribution avoidance of $2,500 to $5,000. Similarly, most advisors won’t want to jump through these hoops if the savings will be immaterial to the client. That percentage is typically set at 0.25% to 0.50%.

Let’s say an advisor sets materiality at $1,000 and 0.50%. Assume ABC Small-Cap Fund is distributing long-term capital gains equal to 10% of NAV. Portfolio allocations typically contain 5% small cap. Capital gains distribution avoidance for the ABC fund would only be material, from a dollar standpoint, for portfolios in excess of $1 million ($1 million times 5% times 10% times 20% capital gains rate equals about $1,000). However, a $1,000 tax savings on a $1 million portfolio is 0.10% of the portfolio. Thus, it is impossible to meet both materiality thresholds, so the advisor would not run calculations on this fund.

Now let’s say the ABC fund is a large-cap fund where the average holding is 25% of the portfolio. From a dollar standpoint, the $1,000 minimum savings will be met for portfolios as small as $200,000. Because this amount meets the 0.50% threshold, capital gains distribution avoidance for the ABC fund should be pursued for portfolios exceeding $200,000.

Will this exercise take effort? Of course. Will it help avoid angry clients at tax time? For sure! Can you let your clients know you did this for them? Yes, you can, hero!

The views expressed in this article do not necessarily reflect the views of Morningstar.