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Help clients dodge a nasty December tax surprise

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This has been a taxing year for many clients in many ways, and it could get even tougher — investment-wise — unless financial advisors take action to help clients steer clear of a potentially painful (and surprising) 2020 capital gain payments from mutual funds and ETFs.

With extraordinary COVID-19-related portfolio volatility and outflows, tax considerations may be among the last thoughts on many portfolio managers’ minds. But with December fast approaching, now is the time for planners to be proactive and focus on reducing clients’ tax burdens. Those who put off this important task until the last month of the year may find they have missed the boat.

Happily, it appears many advisors are beginning to heed the call. In a recent Russell Investments’ survey of U.S. financial advisors, tax-managed portfolios topped the list of strategies expected to play an increased role in their clients’ portfolios in the second half of 2020 not to mention 42% of those advisors surveyed selected “tax-managed strategies” as their No. 1 choice.

There’s historical precedent for this. As the S&P 500 plunged 37% during the global financial crisis of 2008, many investors likely received an unwelcomed December gift of coal in their stocking — an average taxable capital gain distribution of 8%. Similarly, in 2018 — a year that saw relatively large mutual fund outflows — many likely were surprised again at year-end by an average distribution of 11%.

Well, what have we experienced in 2020? We saw the fastest 30% market drop in recent history followed by the best quarterly return since 1998 — all in the second quarter!
What did investors do with this market volatility? They sold $336B in the month of March alone, and those outflows were nearly three times the largest monthly outflow ever. That selling pressure on mutual funds/ETFs combined with another uncertain market year should have advisors thinking about their taxable investment portfolios. Many investors don’t understand how it is that they can lose money while staying invested and still receive an extraordinarily large tax bill at year-end. Talk about adding insult to injury.

Reasons to be tax-aware

If I haven’t yet convinced you of the urgency of this mission, consider these factors:

  • Many mutual funds showed a lower net asset value at mid-year 2020 than they did three years prior, particularly those that focus on value, small-cap, or international investment objectives
  • The massive $3 trillion (and counting) CARES Act stimulus, which was passed in early 2020 to offset the economic impact of the COVID-19 pandemic, will put unprecedented pressure on the federal budget. Who’s going to pay for this? Individual taxpayers are the largest contributors to federal revenue, accounting for 41% of total collections. History tells us that as we emerge from this recession, lawmakers will likely increase taxes to pay down the massive amounts of debt that paid for these stimulus programs.
  • The sunsetting of the U.S. Tax Cut and Jobs Act after 2025 will likely mean reversion to higher tax rates and requires planning.

Beating the holiday rush

As we look to the final few months of 2020, there’s no time like the present for advisors to focus on reducing their client’s tax burdens.

But how? Here’s an approach:

  • Identify current clients/prospects who don’t like surprises and don’t like paying more than their fair share in taxes.
  • Pull the information on their mutual fund holdings, including purchase NAV and current NAV, and sort them by unrealized gains/losses. A result of close to zero means minimal cost to switch to a tax-managed solution, while a negative number means you’re harvesting a loss for the client — a tax asset.
  • Then, explore with them how a tax-managed solution now could address year-end — and ongoing — tax surprises.

Amid all the stress, clients should know that extreme volatility can be a time of opportunity — not fear. Advisors who counsel clients to focus on what they keep, rather than what they make, will be better positioned to take advantage of this market volatility. The old farmer’s adage goes, “Make hay when the sun shines.”

The volatility we’ve seen throughout 2020 has created many sunny days for tax-managed strategies to harvest losses — not just at year-end, but all 12 months of the year.

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