Avoiding The Capital Gains Distribution Trap

Sheryl Rowling's new Practice Wise column is available first in Morningstar Office Cloud.

As an “old-timer,” I remember 2008. Now, 10 years later, there are still plenty of lessons to remember, including those around tax management of client portfolios.

That year, the S&P 500 dropped by over 38%, and most other asset classes declined substantially as well. Although our clients were diversified, the majority still lost between 20% and 30%. Advisors like me did our best to reassure investors: “Stay the course.” “Think of the long run.” “Don’t panic.”

Fast-forward to spring 2009. It turned out that a large number of mutual funds had distributed huge capital gains just prior to the end of 2008. How could this be? Well, these funds had held positions for a long time, building up a high amount of appreciation. The downturn of 2008 didn’t offset all the unrecognized gains. Then, as fund investors became nervous and sold, that forced the funds to recognize gains as they met the redemptions. Some of these distributions exceeded 20% of fund value! Who was left to pay taxes on these gains? Unfortunately, it was the investors who had stayed the course.

Imagine the response of a client who would have seen her $1 million portfolio drop to $700,000, only to then face an unexpected taxable paper gain of $200,000!

Today, 2018 is shaping up to be a down year for the market while a good number of mutual funds are expecting to make big capital gain distributions. Be warned: Don’t let your clients be surprised come April.

How can advisors prevent their clients from having to pay tax on phantom income? The answer is: 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. Christine Benz has a helpful round up of notable distributions from major fund families.

There are two caveats to this strategy: 1. Be sure to have alternative positions with lower distributions, so your clients will continue to be fully invested in the interim. Simply selling a high-distributing fund and holding cash until after the posting date could potentially cost your clients even more money should the fund value appreciate. Investing in a similar position that has little to no estimated distributions will enable clients to maintain their strategies. For example, if "Apex" small-cap value fund is estimated to distribute 12% of net asset value on Dec. 18, you might want to sell Apex and purchase "Bpex" small-cap value exchange-traded fund, which will not distribute any capital gains. Note that you should feel comfortable holding the substitute position for the long term should it appreciate in the interim. Thus, 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.

2. Beware of generating gains when selling. The tax savings on the avoided distributions must exceed the potential tax costs of selling. In other words, 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.

One last note. It can be a lot of work to run calculations for every position held by every client. Limit your calculations solely to clients who hold a material amount of particular funds with disproportionately high distributions.

A way to determine materiality is to decide 1) what minimum amount of dollar savings would be meaningful to clients and 2) what minimum percentage savings would be meaningful to clients.

For example, in my firm, we look for a tax savings of at least $3,000 or 0.50%. For example, let’s say that the Apex small-cap value fund is distributing long-term capital gains equal to 12% of net asset value. Portfolio allocations typically contain 8% small-cap value. Capital gains distribution avoidance for the Apex fund would only be material, from a dollar standpoint, for portfolios in excess of $1,560,000 ($1,560,000 times 8% times 12% times 20% capital gains rate equals about $3,000). However, a $3,000 tax savings on a $1,560,000 portfolio is less than 0.2% of the portfolio. Thus, we would not run calculations on this fund.

Now let’s say the Apex fund is a large-cap blend fund where the average holding is 23%. From a dollar standpoint, the $3,000 minimum savings will be met for portfolios as small as $540,000. Because this amount is in excess of 0.5%, we would pursue capital gains distribution avoidance for the Apex fund held in portfolios exceeding $540,000.

Will this exercise take effort? Of course. Will it help avoid angry clients at tax time? For sure!