This tax season could turn out to be particularly uncomfortable one for mutual fund investors and their advisors. Despite losses or small gains in most major markets last year, many mutual funds distributed capital gains to investors who, in turn, have to pay taxes on those gains even though they made little or no profit on those investments and may even have incurred losses.
This “double whammy” is even more pronounced if the fund distributions were short-term capital gains, which are taxed at an investor’s income tax rate rather than the lower long-term capital gains of 15% or 20% for many investors, depending on their tax rate. (The 2015 capital gains rate is 23.8% for investors with a modified adjusted gross income above $413,200 filing as a single taxpayer or above $464,850 for those filing jointly as a married couple.)
“There is a general lack of understanding of the headwinds that taxes cause,” says Frank Pape, director of consulting services for Russell Investments’ private client services group.
For one thing, taxes can turn fund gains into losses. Take the example of a $100,000 fund portfolio that gained 0.5% before taxes, or $500, and distributed 10% of its NAV in capital gains (the average distribution was 9.7%, in 2015, according to Pape). That would cost an investor in the top tax bracket slightly more than $2,300, turning a $500 gain into an $1800 loss.
This tax liability is a “hidden expense ratio” that advisors and investors should consider when choosing mutual funds, says Pape.
He says the average equity mutual fund has given up more than 1% a year in taxable distributions over the past 10 years, and the forfeiture is not limited to actively managed funds. While actively managed large-cap funds have forfeited 1.17% to taxable distributions, passively managed large caps have given up 0.8%, says Pape. The numbers are even higher for small-cap funds.
In 2015, taxable contributions were especially high for a number of funds. Of the equity funds that distributed capital gains, 15% had a distribution that was greater than 15% of their NAV.
Pape favors actively managed funds that are also focused on managing tax liabilities by harvesting tax losses throughout the year, with a constant awareness of differentiating between short- and long-term capital gains (Short-term gains are taxed at higher income tax rates for most investors).
Advisors should also be aware of a fund’s turnover but not necessarily in the conventional way that assumes higher the turnover means higher trading costs and possibly higher taxes. There’s good turnover and bad turnover, and good turnover is when funds sell assets to harvest losses, says Pape.
He also suggests that advisors focus on a fund’s holding periods for assets because assets held for one year or less qualify as short-term capital gains, which are taxed at income rates rather than lower capital gains rates. In addition, Pape recommends that advisors check the tax profile of funds on Morningstar. It includes a fund’s history of tax-adjusted returns as well as potential capital gains exposure.
Pape also recommends tax-managed mutual funds over other funds because their portfolio managers, unlike other managers, can’t afford to be agnostic about taxes. They can incur costs in the name of lower taxes because that is what their shareholders care about while other managers can’t add to costs that don’t benefit all shareholders equally, says Pape. Pape also prefers tax-managed funds to ETFs, noting that their toolkits can produce after-tax returns.
Russell Investments has three tax managed equity funds — large-cap, small-cap and international fund with developed and emerging markets — as well as two muni funds.
— Related on ThinkAdvisor:
- 15 Most Overlooked Tax Deductions
- Mark Your Calendars: Key Tax Planning, Filing Dates in 2016
- When a Muni’s Tax Efficiency Doesn’t Mean Better After-Tax Returns