1. Attitude: Firm Hold When a client definitely wants to keep their holdings, the next step is to find the best way to reduce their income tax pain, Benz recommends. One way, she says, is to “negate the tax hit by finding [their] way into the 0% bracket for long-term capital gains.”
Strategy: Reduce the Tax Hit
Individual making less than $40,000 and joint filers making up to $80,000 would pay 0% in capital gains. Though fitting this description usually is a long shot for wealthier clients, Benz notes that “2020, the year of income disruptions and waived required minimum distributions, this is a realistic possibility for some.”
2. Another 'Firm Hold' A more likely option is to look for losing positions that can be used to offset distributions. This is more possible in 2020, in which the market had stocks, especially growth markets, doing well, and others doing poorly. Using the specific share identification method for tracking and reporting cost basis “[clients] will be able to cherry-pick specific, higher-cost loss of stocks or funds to sell that would yield a tax loss, leaving lower-cost shares (with higher tax burdens) intact,” she says.
Strategy: Harvest Losses
4. Consider using cash. “If you’re going to be making annual exclusion gifts, consider using cash or high-basis assets, meaning assets with cost basis close to market value, so the [recipient] isn’t burdened with an income tax on the appreciation,” according to Terry Sylvester Charron, senior family wealth advisor at the firm. She also suggests making a gift of appreciated stock held for more than one year rather than a gift of cash, since the gain on the appreciation never gets taxed. “You should avoid making gifts of stock whose market value is less than its cost basis,” she warns. Instead, sell the stock and donate the cash proceeds, because the loss on the sale of the stock is deductible against capital gains; plus, it can offset as much as $3,000 of ordinary income with any excess and any remaining capital loss carried over indefinitely.
3. Attitude: Good Riddance! This is a tactic for those who want to get rid of a fund that has announced it is making a capital gains distributions. Benz notes clients can sell preemptively and upgrade the holding, and “also swap into something that is likely to be more tax-efficient in the future, such as an ETF.”
Strategy: Sell Preemptively
She adds this strategy may not cost much in taxes, either, largely because funds that make these sizable distributions in 2020 are “serial distributors, that made big payouts in 2018 and 2019. “The net effect of that action, if [a client] reinvested [their] distributions is that [they] received a step-up in cost basis.”
This means that clients have “effectively prepaid part of the tax bill in previous years,” she explains.
Capital gains distributions can be a conundrum and are among the “least attractive aspects of mutual fund ownership,” says Christine Benz, Morningstar’s director of personal finance, in a recent column.
These distributions mainly affect wealthier investors who are in taxable accounts, and this type of client will generally owe taxes.
Plus, Benz notes, the distributions don’t necessarily coincide with the client’s gains in a fund.
For example, some value-leaning funds are making distributions in 2020 “triggered by redemptions or manager changes,” she says, noting this may happen even though they might be in the red.
“Talk about adding insult to injury!” she adds.
What should you advise clients who are facing these tax consequences?
Conventional wisdom says it’s rarely a good idea to sell in a bull market, because a client could owe taxes on both the capital gains distribution and the difference between the cost basis and what the client’s shares were worth at time of the sale, Benz states.
A better gauge is how the client feels about holding or selling. The Morningstar expert provides three strategies on how to deal with this dilemma.
— Related on ThinkAdvisor: