Dollar cost averaging … in reverse!
Welcome to the “new normal,” where tax rates (both on income and on capital gains) are higher, new taxes apply and many mutual funds are distributing gains. The impact of this “new normal” on many investors’ after-tax wealth has the potential to impair their ability to achieve their investment goals. Including retirement. This is all mindful of the fact that tax-managed investing isn’t for everyone and suitability is based on personal financial situations, individual tax situations and risk tolerance levels. A tax liability may occur in some cases; the merits of using a tax-managed solution should be evaluated in conjunction with a financial advisor or tax professional.
But every cloud has a silver lining.
The silver lining here, in my view, is that it gives advisors a great opportunity to help make a difference for their clients by helping get their taxable accounts on the right track; a long-term, goal-oriented track where tax-managed solutions are the core of the portfolio, if appropriate.
Here are some tips for how to address this with clients – especially those who are concerned about large gains and tax bills. This is a three-step process over a period of several years for transitioning non-qualified assets, or those assets that do not qualify for any type of “tax break,” into an appropriate tax-managed solution.
This process is designed to minimize unexpected taxable impacts and improve the after-tax outcome for both the client and the advisor. Of course, these ideas may not be appropriate for every investor, but this can give you a sense of the type of considerations that might be beneficial. Depending on the client’s cost basis and tax bracket, the below may need to be modified to fit their specific situation.
Step one: Turning lemons into lemonade
Let’s consider a hypothetical scenario in which you have a client who took a tax hit with their 2013 mutual fund capital gains distributions – the “lemon.” That tax has already been incurred – but there’s potentially an opportunity to turn it into a positive event now if your client elected to reinvest those distributions, as many investors do.
If that’s the case, then there is a good chance that newly purchased, high-cost net asset value shares are sitting in your client’s account. Consider redeeming those shares (at what’s likely to be either a very small gain or possibly even a taxable loss) and transitioning the cash into an appropriate tax-managed solution. Of course, you’ll need to consider the suitability factors of the sale as well as the purchase.
Step two: Making more lemonade
Even if 2014 winds up being a weak or negative returns year, some of your clients may see distributions because many mutual funds have built up gains over the most recent five-year bull market. If you want to avoid reinvestment of potential 2014 distributions and provide funds to use in a tax-managed solution, consider setting up your clients’ accounts to pay gains out in cash in December 2014. That may provide you with additional proceeds to then move into the tax-managed solution you selected in step one. Please note, this does not reduce the 2014 tax liability the client may be incurring, but could reduce future tax liabilities. Of course, dividends paid in cash will still be subject to tax liability.
Done correctly, minimal additional gains will be incurred while potentially moving a sizable portion of the client’s assets into a tax-managed option. The first two steps in combination could result in up to 50% or more of the assets being transitioned (depending on the size of the distributions).1
Step three: The final transition
If you are looking to avoid the impact of taxable distributions for a client in 2015, consider redeeming the remaining shares of mutual funds that aren’t tax-managed before the funds’ fiscal year-end in 2015. Of course, doing this will eliminate any 2015 capital gain and dividend distribution. This could cost the client actual dollars. Any capital gains incurred will apply to the individual investor’s 2015 tax year, which will be filed in 2016.
Assuming you followed this three-step process, these gains may largely be classified as long-term and thus more preferentially taxed at the federal level. Yes, there will be a tax cost but it will conceivably be lower than the alternative would have been.
Of course, this shouldn’t be considered tax advice and you and your clients need to carefully assess their individual situation before proceeding. Income from investments managed for tax efficiency can be subject to the Alternative Minimum Tax and/or any applicable state and local taxes.
Robert Kuharic, CFA, is a Portfolio Manager, Tax Managed Strategies, in the Investment Division.
1 Following the sizable market gains from 2009 through 2014, many active mutual funds have used up their tax-loss carry forward and have been distributing capital gains. Depending on the market returns and mutual fund results of the 2014 fiscal year, the two-year combined capital gain distribution of a number of mutual funds could equal up to 50% of net asset value or more.
Strategic asset allocation and diversification do not assure profit or protect against loss in declining markets.
Dollar-cost averaging does not assure a profit or prevent a loss in declining markets, and you should consider your ability to continue investing during low price levels.
Tags: tax talk