As we approach the end of the year, investors begin to ponder their taxes ahead of next April’s personal filing deadline. For investors, a material portion of their tax liability can potentially come from capital gains.
As most readers know, a capital gain occurs when one sells an asset for more than they paid for it. Without paying close attention, most investors are unaware of capital gain distributions and their associated income tax, which some investors have referred to as “the ninja tax.” Let’s elaborate on capital gain distribution taxation and potential strategies to minimize capital gain impact on investor performance.
When a mutual fund or exchange trade fund (ETF) sells securities that have appreciated in value and the fund doesn't have any offsetting capital losses, it must distribute those capital gains to shareholders in the form of a capital gain distribution. This capital gain distribution represents the distribution of net capital gains to the underlying shareholders of record, but it is not a reflection of the fund’s investment performance for the year. These distributions typically occur at the end of the year, with investors having the option of receiving the distribution in the form of additional fund shares (reinvestment) or cash.
Investors may recognize this capital gain distribution regardless of whether it is reinvested or received in cash, depending on the investment account the position is held in, as noted below:
Tax-Deferred / Roth Accounts (i.e. traditional & Roth IRAs, other tax-deferred accounts) - Investments held in tax-deferred or after-tax Roth accounts will not recognize the capital gain distribution as income.
How investors can effectively manage capital gain exposure
1. Rebalance a client’s portfolio by electing to receive the distribution in cash.
If the client has an overweight position in U.S. Large Cap stocks and an underweight position in international stocks, an advisor could turn off the capital gain distribution reinvestment for U.S. Large Cap stocks, forcing the distribution to cash, and then re-invest the cash into international stocks.
2. Skip year-end distributions by selling positions with unrealized gains that are lower than the estimated capital gain distribution.
Toward the end of the year, when a majority of capital gain distributions occur, investors should evaluate their current holdings compared to the anticipated capital gain distributions. Mutual funds typically release distribution estimates weeks prior to the actual distribution. As an example, let’s assume you have an unrealized gain of 3% in a mutual fund position compared to the mutual fund company’s estimate of a 5% capital gain distribution. You could sell the position, trigger the 3% unrealized gain, and “skip” the 5% distribution, thereby saving 2% in additional capital gains.
3. Take advantage of tax loss harvesting opportunities throughout the year.
During the year, one or more of our funds may be at a capital loss due to near-term capital market volatility. When those opportunities arise, investors will want to take advantage of the capital loss in a fund by selling it (locking in the capital loss), replacing it with an equivalent fund (typically an ETF that trades commission-free) that is held for at least 31 days, and then re-purchasing the original security after the wash sale period has concluded.
By doing this, the investor maintains their exposure to the asset class, while harvesting a capital loss that can be used to offset other capital gains throughout the year. In addition, should investors’ capital losses exceed their gains in a tax year, investors can deduct these additional losses to offset ordinary income, up to $3,000 per year, with any additional losses eligible to be carried forward to future tax years.
As we have illustrated, it is important for investors to be cognizant of capital gains and capital gain distributions to maximize their after-tax investment performance.
Schneider Downs Wealth Management Advisors, LP (SDWMA) is a registered investment adviser with the U.S. Securities and Exchange Commission (SEC). SDWMA provides fee-based investment management services and financial planning services, along with fee-based retirement advisory and consulting services. Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice. Registration with the SEC does not imply any level of skill or training.
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Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax, or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice.