Sheryl Rowling

Near year-end, mutual funds allocate recognized internal capital gains to shareholders. Although tax basis is increased by the gains recognized, investors must pay tax on phantom income—the revenue that doesn’t come with cash payouts. Frequently, these distributions are not material.

However, in some years, certain funds can distribute significant capital gains. When this happens, investors can get upset by an unexpectedly higher tax bill.

From an advisor’s perspective, capital gains distributions can negate any effort made to defer a clients’ gains through tax-loss harvesting or other methods. And mutual funds could be doling out large capital-gains payouts again this year, according to Morningstar’s Christine Benz. Advisors who want to prevent clients from being dissatisfied should try to avoid material distributions.

4 steps to avoid capital gains distributions:

1. Identify your clients’ mutual funds that are distributing disproportionately high capital gains per share.  This process is neither simple nor fast without the use of technology. However, there is a manual aspect to this step, because there’s currently no data feed for estimated capital gains distributions. Most advisors work with only a handful of fund companies, so scanning gain estimates for material distributions shouldn't be overly burdensome. Alternatively, the site CapGainsValet contains distribution information from most fund companies as well as other helpful tips.
2. Identify substitute positions that are not distributing high gains. Typically, there will be only a few funds for which a replacement is suitable. The replacement should have lower or no estimated distributions and be acceptable for long-term holding (in case of appreciation).
3. Identify clients who hold a material amount of the identified funds. Even if a fund is distributing disproportionately high capital gains dividends per share, if the client doesn’t have significant holdings of the fund, it’s probably not worth the trading costs to save just a few bucks.
4. Calculate trades for those clients—only when the trades produce a material savings. The calculation for determining any savings from avoiding capital gains distributions is:

4 ways to lessen the burden of calculating capital gains

Determinating whether a trade will produce meaningful savings will be time-consuming for advisors who are manually implementing an avoidance strategy for capital gains distributions. However, they can limit the number of required calculations by weeding out:

1. Funds without material capital gains distributions.

2. Funds for which a suitable replacement cannot be identified.

3. Clients who don’t have a significant holding in the fund.

4. Clients whose holdings in the fund are highly appreciated.

Increasing impact and efficiency

Advisors can make a big impact on their clients’ tax bills. And although it may be possible to do without automation, rebalancing software like Morningstar’s Total Rebalance Expert, or TRX, can provide automatic tax minimization as well as overall streamlined portfolio management. The benefits of increased efficiency and a greater competitive edge should easily overcome the cost and time involved with adding new technology.