What will capital gains distributions look like in 2020?
The bear/bull market paths in 2020, coupled with disparate outcomes among different equity classes and heavy redemptions early in the year, will leave a range of capital gains distribution outcomes. An early Morningstar summary of fund distribution estimates across more than 15 major mutual fund companies confirms this, with a reasonable range of capital gains distributions between 6% and 12% of net asset value. Conservatively assuming a long-term holding period for all sales, this suggests that most funds will incur a tax drag on their performance of 1.4% to 2.8% for the year after capital gains distributions. In a year when most funds and equity classes finished in positive territory, perhaps this is a pill the taxpayer is willing to swallow, given the positive pretax performance delivered by the manager. After all, positive returns and, ultimately, gains are the goal of investing, and tax drag is a part of that equation.
Separately managed accounts can do the taxable investor one better. The beauty of maintaining a portfolio under the individual investor’s own tax ID is that the investor has full ownership of capital gains and losses. Using a tax-managed passive core portfolio maintains equity exposure but passes through capital losses, effectively offsetting any capital gains distributions from mutual funds or other investments, thereby reclaiming, in part or in whole, the tax drag incurred. In fact, 2020 was a successful year for tax-managed passive investing. Accelerating capital losses, deferring capital gains, and managing relative exposure to the investor’s benchmark of choice resulted in both substantial pretax returns in 2020 and significant tax benefits from losses taken early in the year. In years with very few capital gains to offset, the investor can bank capital losses and carry them forward for future years.
Not every year is as fortuitous as 2020 was, from either a pre- or post-tax perspective, but tax management tends to deliver consistently in most years. The outcome varies with market environment, but the odds are predominantly in the taxable investor’s favor, delivering 1% to 2% annually, on average.
The bottom line
The harsh reality is that the economy is still aimlessly lurching from the impacts of the pandemic, and those fits may spill over into tax-filing season. It’s likely that a disproportionate number of filers will have some income and capital gains they weren’t expecting as the result of mutual fund distributions last year. Through an effective tax-managed investment strategy, even a tumultuous year like 2020 can produce benefits. If the investor structures realized losses to manage tax burden, even a difficult year can help you meet your investment goals.
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