By now, most advisors and investors are familiar with the tax increases that went into effect on Jan. 1. And hopefully those investors who were spared the recent tax rate hikes realize that they haven’t entirely dodged the tax bullet because taxes didn’t go away.

Tax considerations have always been important for investors , regardless of their tax bracket, and they’re particularly important this year for investors who hold mutual funds in taxable accounts. That’s because, in addition to high rates, many funds will be nearing the end of their capital loss carry-forwards this year.

Given that 52% of all open-end mutual fund assets are held in taxable accounts, we figured that $6+ trillion-some-odd reasons would justify this tax-focused piece.

Against this backdrop, we wanted to offer thoughts on helping clients navigate this challenging taxable environment. Let’s start at the beginning, though: Why should advisors be in front of taxes.

Why Care About Taxes?

Even before the most recent increase in the top tax bracket, taxes had an out-sized impact on reducing taxable investors’ returns. For the five years ending 2010, taxable equity and fixed income open-end mutual fund shareholders surrendered over 30% and approximately 37%, respectively, of their load adjusted five-year returns because of pre-liquidation taxes.1 Think about these numbers — the power of compounding of the tax drag creates meaningful headwind to your clients’ ability to meet their long-term financial goals.

And there’s more to the story.

Many investors have enjoyed a tax holiday for the last four years: they have experienced very attractive returns since 2008 and have, on average, realized very low capital gain distributions over that period. As a result, many investors and advisors have become complacent about taxes. Particularly investors in mutual funds — since mutual funds are able to carry capital loss carry-forwards into future years to be used to offset future capital gains. The downturn in 2008 was exactly the event that helped create material capital losses that have been used to offset against the attractive returns we’ve seen since 2008. But, for many mutual funds, that’s coming to an end now.

We Have Some Precedent

We’ve seen this pattern before, from 2001 to 2007.

The years 2001 to 2002 saw back-to-back double digit negative returns. This allowed many funds to bank capital loss carry-forwards.For the years 2002 to 2007 you saw attractive U.S. equity returns that line up with increasing capital gain distributions as those losses were used up.

In 2007, the lowest equity return (5.10%) was coupled with the highest capital gain distribution for the period 2001 to 2007. Recall that, by 2007, many investors were much more aware of distributions coming out of mutual funds than today and you may have had some difficult discussions with clients explaining this tax hit. You see a similar trend forming for distributions coming out of 2008. The trend is even more pronounced for many emerging market and sector-specific funds.

So, What Can You Do?

Fortunately, there may be several steps you can take to help your clients invest smartly around the coincidental rising tax rates and likely increasing capital gain distributions. For instance,

  1. Asset location. Consider placing assets that may be inherently less tax efficient (e.g. Commodities, Real Estate Investment Trusts, Sector Funds, Non-U.S. equities, etc.) in tax-advantaged accounts like an IRA, 401k or similar vehicle.
  2. Understand the capital loss carry-forward status of your mutual funds. Many advisors focus on the undistributed capital gain within a given fund. Because of the possible size of the capital loss carry forward, the undistributed gain is only part of the story.
  3. Understand how the fund approaches tax efficiency. if at all. Was the attractive after-tax return you are evaluating achieved incidentally or purposefully by the mutual fund? Note that if the fund’s investment objective does not explicitly mention investing for tax efficiency, that mutual fund cannot incur any expense that doesn’t benefit all shareholders equally. A fund that is designed and positioned to be tax-aware will be able to harvest specific stock losses in a given year and use that loss to offset against realized gains across the fund. A non-tax aware fund could not purposely harvest losses because that transaction cost would not benefit the tax-advantaged shareholders. Remember, portfolio turnover is not necessarily a bad thing in some situations.
  4. Is there an efficient method to make a manager/fund change? Often, changes within a specific fund (e.g. key personnel departure, fund grows too big too fast, underperformance, a higher conviction manager becomes available) may require a manager or fund change. Often, taxable accounts make this manager/fund replacement decision much harder because terminating a specific manager/fund (which requires liquidating the entire fund and moving to the new fund) may cause a taxable event – the very thing you’re trying to manage. Of course you don’t want the tax tail to wag the dog, but it will certainly be a consideration. There are methods of replacing a manager that may be more efficient.

Can you accurately quantify the impact that taxes have on your clients’ portfolios? This is an issue that you should be in front of today, not after the fact. The (im)perfect storm of increasing tax rates and tax burdens coupled with many funds likely using up their capital loss carry-forwards, requires heightened focus on tax implications for investment portfolios. At Russell, we believe the partial list above should be incorporated into your investment process to help clients attempt to achieve their long-term financial goals.
Frank Pape is Director of Consulting Services, Private Client Services, for Russell Investments. For more information visit the Helping Advisors Blog.



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