With the raging bull market of the past few years, however, most funds have already exhausted their capital losses, so they now must pay taxable distributions to shareholders. Indeed, Morningstar estimates that as much as 17% of mutual fund assets may be paid out in distributions this year.
With that in mind, advisors should reach out to their clients and start planning strategies for offsetting taxes resulting from fund distributions. The tax bite of distributions from funds held outside of tax-qualified accounts can be particularly stinging for investors who have instructed their fund providers to automatically reinvest distributions in additional fund shares. In such cases, investors don’t receive the distributions in cash, so it may feel like they are paying taxes on income or capital gains that they haven’t received.
Even worse, funds that have experienced a decline in their share prices but have accumulated capital gains may also need to make taxable distributions. Yet, advisors can implement strategies to help lessen the tax impact of fund distributions.
Advisors should look for investments outside of tax qualified accounts that can be sold at a loss. In such cases, the losses can potentially be used to offset taxable distributions. Selling an investment, such as a stock at a loss, of course, can result in missing out on any gains that may follow temporary market declines. Therefore, some advisors may seek to sell the depreciated stock and then invest in a similar security to capture future appreciation.
The challenge is to do so without violating tax regulations that prevent investors from selling a security to realize a loss and then quickly buying an identical security. With that in mind, it may make sense to consult an accountant when planning to harvest capital losses.
Advisors should also seek other ways to lower clients’ taxes. For example, it may make sense to have clients fund tax-deductable IRAs or increase the portion of end-of-the-year annual bonuses that are diverted into retirement plans. It may also be beneficial to work with an accountant to look for other tax deductions.
Clients’ concerns over taxable fund distributions may also present an opportunity for advisors to strengthen their existing relationships by conducting longer-term tax planning. For example, advisors can illustrate how increasing contributions to qualified retirement plans can lower clients’ taxable income. While doing so will reduce the amount of income that is taxed, it may also place clients in a lower tax bracket.
As such, future distributions from funds held outside of a retirement program will be taxed at a lower rate. Taxation of distributions and other gains from funds held within retirement plans, of course, will be deferred until the assets are withdrawn from the qualified programs.
It’s also important to keep portfolio management fundamentals in mind. Buying mutual fund shares outside of a tax-advantaged account in the final weeks of the year can be a costly mistake, as new fund investors will be subjected to taxes on fund distributions.
Advisors should also propose using tax efficient mutual funds or portfolios. For example, index funds typically have a low turnover of portfolio holdings, so they are generally considered to be tax efficient. Broadly speaking, when funds sell securities at a profit, they generate gains which must be distributed to shareholders.
That problem can be minimized by reducing portfolio turnover of holdings. Some fund firms also offer actively-managed funds that are tax efficient. Broadly speaking, they seek to minimize portfolio turnover. In a similar manner, advisors seeking to sell securities at a profit from non-tax advantaged accounts during the final weeks of the year should evaluate if they can delay the transactions until the next year. By doing so, they can delay taxes on the capital gains for a full year.