The 4 A’s of Preparing for Capital Gains Season

Tax proposals and changes to the tax code are a near daily story right now. The number of proposals and quick takes are likely to increase as we head into the fall. We all know what that means: Client questions and conversations about what may, or may not, happen to tax rates—and more importantly—the potential impact on their portfolios, and what steps can be taken today to help manage that potential impact.

While investors wait for clarity on uncertain tax rates, there are actions advisors can take now to prepare for the certainty of capital gains and related taxable distributions. After all, fall/winter is the time of year when most mutual funds post their estimates for capital gains distributions and related taxable events. And it is not just capital gains that erode after-tax returns. Dividends and interest payments also reduce after-tax return of both passive and active strategies and they are paid throughout the year.

So, how can you prepare for these taxable events? Think of these four A’s:

Four A’s of preparing for capital gains season

4 A's of preparing for capital gains season

1. Awareness

How big of a problem is tax drag? Looking at data across all investment products (active mutual funds, index funds and ETFs) reveals that the return lost to taxes is typically higher than the average net expense ratio. Another way to think of these lost returns is that they have been subjected to a government expense ratio. Awareness of the size of the tax drag can open your eyes to its pervasiveness across your clients’ accounts. We believe reducing this tax drag is one of the best ways to justify the fee you charge and demonstrate your value in working to improve after-tax outcomes.

Return lost to taxes versus fund fees – Three years ending Dec 2020

Tax impact

Source: Morningstar. U.S. Large Cap: Morningstar U.S. Large Blend Universes average, U.S. Small Cap: Morningstar U.S. Small Blend Universes average, Fixed Income: Morningstar Taxable Bond Universes average. Tax Drag: Morningstar Tax Cost Ratio