As we head into the final weeks of 2014, are you and your clients prepared for the capital gain that many mutual funds are likely to pay out before year-end? Even with the equity volatility we saw in October, U.S. stocks (represented by the Russell 3000 Index) were up 12.7% for the year through Dec. 4, 2014 and up a cumulative 110% over the last 5 years ended Dec. 4, 2014. As it has done in the past, this type of market appreciation has created a sizable tax bill for many mutual funds in 2014.

HISTORICAL MARKET RETURNS & DISTRIBUTIONS

History isn’t a predictor of future returns, but it can be a helpful guide to understand the past relationship between market returns and mutual fund capital gain distributions. Looking at last year, mutual funds distributed $239 billion in capital gains to shareholders. While this is a huge amount, history suggests that it is likely going to get worse from a tax perspective.

Recall that U.S. equity markets were negative in both 2001 and 2002 (Russell 3000 Index was down -11.46% and -21.54%, respectively). From the exhibit above, you can see how this contributed to low capital gain distributions in 2002.  Conversely, as U.S. equity markets improved from 2003 to 2007 (annualized return of 13.63%), the level of capital gain distributions increased, reaching an eye-popping $414 billion in 2007. What’s interesting is that distributions peaked in 2007, even though equity market returns in 2007 were lower than they had been in any calendar year since 2003.

THE POSSIBLE SITUATION TODAY

A similar pattern may be set to play out this year. With equity markets having experienced strong gains over the past five years, some pundits predict mutual fund distributions for 2014 will be in the neighborhood of 16% – 17% of the investment value, according to a Reuters article entitled “The tax hit that loyal investors will take in 2014.” For context, consider that in 2013, 51% of equity mutual funds made a capital gain distribution, and nearly 75% of these distributions were more than 2% of their investment value, according to the 2013 Investment Co. Institute Factbook. For the 2014 distributions, they likely will be subject to the higher tax rates that have been in effect since the 2013 tax year.

One can only hope that the distributions will be paid as long-term capital gains – not short-term. Even for those investors in the highest tax bracket, the long-term rate is materially lower than the short-term rate.

 

WHAT TO DO FOR CLIENTS?

Of course, as an advisor you can’t influence whether the distributions will be characterized as long-term or short-term, and for assets held in taxable accounts, the tax will be due at some point for appreciating assets. But depending on your client’s individual situation, the investment process may be able to defer the gain recognition until a later date, which can have a powerful impact on compounding over time.

Also, you can be on top of the estimated capital gains for the year that most fund companies typically publish at this time of year. Understand how these distributions stack up. Take the time to understand the investment process that generated the after-tax return and taxable distributions. Is the investment process designed to manage taxes? Processes that may help reduce taxes over time can include the following:

  • Select lower turnover managers
  • Tax lot swapping
  • Manage holding period
  • Defer realizing gains
  • Tax loss harvesting
  • Minimize wash sales
  • Optimal tax lot selection
  • Transition management
  • Manage fund’s yield

Investment processes utilizing any of these types of strategies may be able to dial down the taxable distributions and work to defer recognizing taxable gains.
THE BOTTOM LINE

Help reduce sticker shock for your clients by discussing with them the potential for capital gains taxes well in advance of their tax bill arriving. It’s likely that taxable distributions for many investors are going from bad to worse.

Frank Pape is the director of consulting services for Russell’s U.S. advisor-sold business. To see this article in its original form, with more information and full disclosures, visit Russell's Helping Advisors blog.

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