The Year End Gift You May Not Be Expecting
This has been a difficult year for stock and bond investors. After several years of above average performance, the broad based market index returns have been negative this year, reducing portfolio values relative to where they started the year. For example, through 10/31/2022, the S&P 500 index is down -17.72% since the start of the year and the ICE Bank of America 1-5yr US Corporate Bond Index is experiencing a -8.22% decline over the same time period. While these types of market fluctuations should be expected from time to time, investors should be aware that just because your portfolio is down, that does not mean you will avoid capital gains taxes this year.
Typically, “buy and hold” investors of individual stocks and bonds have the flexibility of if, and when, they realize capital gains or losses on individual security positions held in their portfolio. In a year like this one, investors have multiple opportunities to capture losses and offset gains for crucial portfolio repositioning. This is a great opportunity to make changes to your overall allocation or add to underweight sectors in your portfolio.
However, many investors also hold mutual funds as part of a diversified portfolio. And here is where things get complicated. As we approach the end of the year, many clients ask about the realized capital gains or losses in their taxable accounts in order to prepare for next year’s tax return filing. This is a good time to remember that many mutual funds will still pass along capital gains to their shareholders, even when the price of the fund is down and you have sold no shares in your portfolio. In down markets, many investors sell out of their mutual funds, which results in the fund manager selling shares and creating a distribution to all remaining shareholders. Depending on the fund and the level of trading activity during the year, the gains distributions can be significant.
One way to avoid a large capital gains distribution if you purchased a fund earlier in the year and you currently have a loss, is to sell the fund prior to the ex-dividend date. This way you realize a loss on the investment and avoid the taxable gain distribution that you would otherwise receive, if you held the fund through year end. You can use the sale proceeds to invest in another investment, as long as you are mindful of the “wash sale” rules.*
Being mindful of the mutual funds you are investing in can have a big impact on future tax implications. Take a look at the turnover ratio of the fund and whether or not there has been a recent change in the portfolio manager of the fund. When a new portfolio manager takes over, they often want to put their ideas to work and that may mean selling current positions that have large gains. Funds with higher turnover ratios are purposely more actively managed, as they attempt to beat the index returns and therefore have the potential to pay out more gains each year. Another data point to review is the inflows and outflows of the fund. As mentioned previously, funds with high outflows may be forced to sell positions that have gains in order to meet redemption requirements during the year, and those gains must be passed on to the remaining shareholders.
If you want to buy a particular fund near the end of the year and are worried about future capital gains ramifications, you can wait to buy until after the fund pays its distribution for the year. Another tactic is to purchase the fund in a tax-deferred account so that annual distributions are not taxable to you in the year they are paid.
Over the years, investing in high performing investments is an important factor in managing your portfolio. Selecting a mutual fund, or other investment, that makes periodic gains distributions is not a disqualifying factor. However, it is a good idea to check on your mutual fund holdings before year-end to make sure any capital gains distributions are included in your tax planning.
*(Please consult with your tax advisor before making these types of transactions.)
Read the Financial Planning Focus November 2022:
"Recessions and the Stock Market" by Glenn Gaurd, CFA »
"Gauging Forward Return Expectations" by Ryan Streilein, CFA »
Important Disclosures
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This information is intended to be educational in nature, and not as a recommendation of any particular strategy, approach, product or concept. These materials are not intended as any form of substitute for individualized investment advice. This information is intended to be educational in nature, and not as a recommendation of any particular strategy, approach, product or concept. These materials are not intended as any form of substitute for individualized investment advice. The discussion is general in nature, and therefore not intended to recommend or endorse any asset class, security, or technical aspect of any security for the purpose of allowing a reader to use the approach on their own. You should not treat these materials as advice in relation to legal, taxation, or investment matters. Before participating in any investment program or making any investment, clients as well as all other readers are encouraged to consult with their own professional advisers, including investment advisers and tax advisers.