As the last vestiges of summer quickly fade, people throughout the region begin turning their attention to winter activities and the impending holiday season. Accompanying every change in seasons is a unique set of to-do items, and one such activity that Greenleaf Trust advisors actively anticipate this time of year is the emergence of annual capital gains distributions. These distributions, traditionally made in late November to mid-December, can create a tax liability for investors regardless of whether they have recently sold shares. For us at Greenleaf, advisors begin preparing for this annual event well in advance, with the goal of ensuring the best tax outcomes for each client through the management of capital gains distributions. Given the financial implications of these distributions, we believe a robust and strategic plan that is cognizant of each client’s unique circumstances can prove remarkably additive to an investor’s long-term capital appreciation. To explain capital gains distributions and how Greenleaf approaches taxes in fund portfolios it is our pleasure to once again share with you this article on the topic.

Most investors are familiar with basic tax principals for individual shares of stock. Mr. Smith buys shares of ABC Company for $100 and sells them for $110 realizing a $10 profit, or gain, on which he is expected to pay taxes. If Mr. Smith holds the shares for more than one year, the gains are considered long-term and subject to a federal tax rate of up to 23.8% (in 2019). If Mr. Smith holds the shares less than a year, the gains are short-term and taxed as ordinary income. The key here though, is that Mr. Smith has to sell the shares to realize the gains. He controls the timing, and has the ability to delay realization of gains and the resulting tax liability for as long as he holds the shares. The same concept is only partially true when it comes to mutual funds.

A share in a mutual fund represents a share in a portfolio of stocks (or other investments), and the price of that share (the net asset value or NAV) fluctuates with the prices of the underlying securities. The mechanics here are really no different than in the individual stock example above. Mr. Smith buys shares of the ABC Fund for $100, the underlying securities in that fund collectively appreciate by 10%, and Mr. Smith sells them for $110, realizing a $10 gain and the associated tax liability. Pretty straight forward right? Here’s where it gets a little more complicated…

If a mutual fund sells a holding in which it has a gain, it has to distribute that gain to the fund’s shareholders in the year it was realized. If the mutual fund buys shares of ABC Company for $100 and sells them for $110, it has to distribute the $10 gain (short or long-term) to shareholders who are responsible for the tax liability. Instead of distributing gains after every transaction, funds typically make a single distribution at year-end which incorporates all gains netted against any offsetting losses or applicable loss carry forwards.

So there are two ways a fund investor can realize gains: 1) by receiving a capital gain distribution from the fund; and 2) by selling a fund share for more than the purchase price. Mechanically, capital gains distributions are processed similarly to dividends. There is a record date (holders of record on this date will receive the distribution), and an ex-date (the first day you can buy the fund without receiving the distribution). This means that a fund could set a record date of December 15 and if our friend Mr. Smith bought shares on December 14, he would receive the distribution and a tax bill. Likewise Mr. Smith could have bought shares earlier in the year and sold them on December 14th and he would avoid the distribution altogether.

Perhaps this seems unfair. The fund accumulates gains all year and then distributes them to whoever happens to be holding the shares on the record date. Fortunately, there is a mechanism in place that prevents fund investors from being taxed twice – specifically, the distribution results in a corresponding reduction to the NAV or price of the fund share, which effectively reduces any gain in the shares themselves.

To illustrate, let’s say Mr. Smith buys one share of ABC fund for $100 on December 14 and the fund distributes $10 in capital gains on December 15. Mr. Smith receives the $10 and will pay taxes on that amount (clearly unpleasant), and his share immediately re-prices to $90. Sounds like a lose-lose, but it means Mr. Smith’s share could appreciate as much as $10 (from $90 back to $100) before he would realize gains on a sale.

For each of the past several years, the average distribution across our client holdings was between three and five percent. This year, our estimate of the average distribution across our client holdings is somewhere between three and four percent. Current estimates show that funds with significant domestic growth equity or global real estate exposures expect to make higher distributions than funds with other types of holdings.

Fortunately, our hands are not completely tied when it comes to taxes. In fact, several steps in our process are inherently geared toward managing tax liabilities generally and specifically as they apply to externally-managed funds. First of all, this discussion does not apply to 401(k)s, IRAs, or other qualified accounts and we ensure clients are maximizing these vehicles in the context of a broader wealth management plan. For non-qualified accounts, our portfolio construction and fund selection processes carefully consider the assumed tax impacts of the strategy or fashion in which our clients are investing. We carefully consider turnover rates, as it is usually the case that higher turnover (more trading) means more realized gains while lower turnover means the opposite. We also evaluate the tax characteristics of different investment vehicles for our clients. This emphasis on tax efficiency is part of what led us recently to increase the use of index-tracking exchange-traded funds (ETFs), which usually experience less turnover and are generally more tax efficient than the average actively-managed mutual fund. We also monitor funds closely for manager or prospectus changes which may drive higher turnover if the portfolio is repositioned. Additionally, we analyze capital gains estimates to inform decision-making around year end — under unique circumstances, there may be benefits to strategic repositioning during the distribution season based on a host of account-specific factors. You can rest assured that we are thoroughly examining every account for opportunities.

Lastly, perhaps a little perspective is in order. Nobody looks forward to paying taxes and rational investors will make every effort to avoid, minimize, or delay them. Greenleaf Trust is in your corner working diligently to ensure that we’re sheltering, minimizing, and delaying every chance we get. But at the end of the day, taxable gains are, well…gains. So don’t lose sight of the fact that while taxes are a certainty, they’re also a certain indicator of a growing portfolio.