Crisp fall air, the cheer of holiday festivities, and time spent with the ones we love are some of the many things we look forward to this time of year. Brutally cold mornings, ice coated windshields, and year-end capital gain distributions, on the other hand, can bring out the grinch in even the most upbeat among us. While there is nothing your wealth advisor can do about the incessant cold – except, perhaps, assist you in developing a plan that enables you to spend time in a more temperate climate during the winter months – your Greenleaf Trust advisor can help alleviate any misgivings surrounding year-end fund distributions and their associated taxes. Capital gain taxes, as the name implies, are taxes collected on the gains realized from the sale of an investment. Over the course of the year, fund portfolios buy and sell securities, and at the end of the reporting period, the funds calculate the net gain or loss derived from these transactions and distribute any net capital gains to fund shareholders. While rising markets may lead to more gains than downward trending markets, many funds continue to generate taxable gains no matter the market environment. While this realization may be unsettling, Greenleaf Trust clients can rest assured that their advisor has been thoughtfully preparing for these distributions with the goal of ensuring the best after-tax outcome for each of our clients. With this in mind, let us now turn our attention to the mechanics of these annual distributions.

Most investors are familiar with basic tax principles 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 2023). 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.

Historically, the average distribution across our client holdings has been between three and five percent. This year, we estimate that capital gain distributions will be on the lower end of historical norms, averaging around three percent.  Domestic large-cap equities are poised to distribute the largest gains this year.

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. In addition, we keep an eye on the net flows of each fund, as large net outflows can force a fund manager to liquidate securities to meet redemptions, resulting in higher realized gains. We also evaluate the tax characteristics of different investment vehicles for our clients. This emphasis on tax efficiency is part of what leads us to recommend index-tracking exchange-traded funds (ETFs) for a portion of many client portfolios, as they 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.