Capital Gain Distributions Are Still Not Your Friend. But Now, Interest Is Also Your Frenemy!
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- Funds will begin paying out their 2023 distributions this month which could lead to a tax bill for your clients.
- While capital gains distributions will likely be lower this year than in recent years, interest income is expected to be higher.
- Embracing a tax-managed approach to investing can help your clients minimize the taxes they pay on both their equity and fixed income holdings.
It's the time of year that investors typically dread: capital gain distribution season! This period brings the not-so-pleasant anticipation of how hefty THIS year's tax bill may become. At the end of every year, both mutual funds and exchange traded funds need to calculate their net realized capital gains (both short term and long term, since two different tax rates apply). The capital gains are realized from trades made throughout the year, driven by both the active investment decisions you made as an advisor, forced trading events, and flows into and out of the funds. The distribution is typically made during the month of December and appears as a "dividend."
This may be confusing to some investors as this distribution isn't a real dividend but a form of "return of capital." These are the distributions that may generate surprise tax bills for many investors. This is not a fun surprise like a surprise birthday party, rather it's an unpleasant surprise since it may mean a higher tax bill than expected.
This year though, the surprise won't just come from capital gain distributions. With cash holdings in the U.S. at a record high, a lot of investors may be surprised to see a larger tax bill due to the interest income they have received. Interest is being paid out from bond funds at a much higher rate than just two years ago. While this is good for those who are invested in tax-free municipal bond funds in their non-qualified accounts, for those investors in taxable bond funds, money market funds, or Certificates of Deposit (CDs), it will most likely result in a sizable increase in taxes paid.
Capital Gains – Zooming in on U.S. Equities
With more than 75% of U.S. equity funds having released their 2023 estimates on capital gain distributions, we have enough information to make an assessment on this year's environment.
First, among styles, the estimated distribution range is between 4%-5% of Net Asset Value (NAV). While there is less variability compared to previous years, growth is leading the way while value is coming in at the lower end of the range. When it comes to the different parts of the market capitalization spectrum, U.S. large cap again is expected to be at the upper part of the 4% to 5% capital gain distribution range while small cap is expected to be at the lower end of the range.
Source: Russell Investments and Morningstar Direct, as of 11/27/2023. Categories based on Morningstar Category Group which includes mutual funds and ETFs (and multiple share classes). The average capital gain distribution % is calculated using the total capital gain distribution and respective pre distribution NAV as reported by Morningstar. % of NAV is calculated as (total capital gain distributions ÷ respective pre distribution NAV).
Delving further, funds within the U.S. large cap equity category are expected to distribute capital gains within a range of 4.5% to 6.0% of NAV. Large cap growth funds are poised to be at the higher end of this spectrum; while large cap value funds are expected to fall towards the lower end of this range.
Among a broad category of mid cap and small cap funds, the expected range of capital gain distributions is 3.5% to 5.0% of NAV. This broad category is a bit of a mixed bag. mid cap growth is expected to come in at the upper part of that distribution range, while mid cap blend and value are expected to be at the lower end. In the middle part of the range sit the small cap categories. Small cap growth and value are expected to distribute about 4%/NAV while small blend funds will likely come in just under mid cap growth.
Capital Gains – Looking at the broad categories
Source: Russell Investments and Morningstar Direct, as of 11/27/2023. Categories based on Morningstar Category Group which includes mutual funds and ETFs (and multiple share classes). The average capital gain distribution % is calculated using the total capital gain distribution and respective pre distribution NAV as reported by Morningstar. % of NAV is calculated as (total capital gain distributions ÷ respective pre distribution NAV).
Taking a look at distributions across all asset classes, the fixed income categories capture our attention. Distributions are expected to be relatively small. But the question that needs to be asked is – why are fixed income funds distributing at all? After a "once in three generations" spiral of dramatic interest rate hikes in 2022, sizable capital losses were built up in fixed income assets, broadly speaking. The fact that a 1.5% distribution is expected in taxable bond funds and a 0.5% distribution in tax-exempt municipal bond funds is a tad surprising and a bit disappointing. You can use this information and data to identify which investments might not be aligned with your clients' taxable interests and needs and turn their attention to fixed income funds that take their after-tax wealth building needs into consideration.
Beyond fixed income, international equity funds are expected to deliver relatively small capital gains distributions. Commodity and sector-based funds are expected to post distributions in the middle part of the overall range. Certain sector fund categories such as technology, real estate and financial services are expected to have higher overall distributions than the sector equity category average while infrastructure and defensive sectors are expected to be at the lower end of their respective range. At the upper end of the range is the non-traditional fund category: this includes funds focused on derivatives and long-short strategies. By their nature, these investment strategies tend to not be overly tax-efficient so their standing at the upper end of the range is not necessarily an outlier.
Source: Russell Investments and Morningstar Direct, as of 11/27/2023. Categories based on Morningstar Category Group which includes mutual funds and ETFs (and multiple share classes). The average capital gain distribution % is calculated using the total capital gain distribution and respective pre distribution NAV as reported by Morningstar. % of NAV is calculated as (total capital gain distributions ÷ respective pre distribution NAV).
Let's not forget interest income
Interest has not been a story when it comes to sizable tax impacts for a number of years. Low interest rates equal low tax bills because there was little interest income. That has now changed with the U.S. Federal Reserve embarking on a sizable interest rate hiking campaign in 2022. Many taxable bond funds have coupon yields now of 5.5% or greater; many money market funds and CDs are offering 4% to 5% interest rates. This is substantially higher than in years past. Since this interest income is taxed as ordinary income, which commands a larger rate than capital gains, investors need to take that into consideration for their year-end planning. While capital gain distributions are expected to be lower than we have seen them this decade, interest rates are near high levels for the decade.
Source: St. Louis Fed, yCharts, Barclays and the U.S. Securities and Exchange Commission. All data as of 11/30/2023, except Money Mkt which is as of 10/30/2023. 10 Year Treasury: daily Market Yield on U.S. Treasury Securities at 10-Year Constant Maturity, Quoted on an Investment Basis, 1 Year CD: U.S. 1 Year CD Rate, U.S. Aggregate Bond: Daily yield to worst for the Bloomberg U.S. Aggregate Bond Index, Money Mkt: Daily Weighted 7 day gross yield on Prime Retail Money Market fund (Fund Statistics [Table 3]).
Tax-exempt municipal bond funds should be a strong consideration for investors in light of this higher interest rate picture. While the coupon yields appear lower on municipal bonds, part of that is due to their tax-advantaged nature. What's important to look at is the tax-equivalent yield, as that paints a more complete after-tax picture for investors.
Source: Barclays. As of 11/30/2023. Yield quoted represents the Yield-to-Worst as of 9/30/2022. Bloomberg Barclays indices: IG Bond = U.S. Aggregate Bond Index; IG Municipal Bond = Municipal Bond Index; Sub-IG Corporate= U.S. Corporate High Yield Index; Sub-IG Municipal = High Yield Municipal Bond Index. Marginal Tax Rate used is 40.8% (37.0% + 3.8%).: Income from municipal bonds may be subject to state or local taxes and/or the federal alternative minimum tax.
Summary – No free tax ride this year
In summary, while capital gains distributions are expected to be lower than the prior two years, there will still be tax consequences. Taxes will need to be paid on the capital gains distributions received; and now there is a new wrinkle to many investors' tax pictures given the substantially higher interest income they may receive. Many investors should not expect a reduction in their tax cost from their investments.
We believe this is a great time to give strong consideration to tax management as part of your new-year planning. Taxes are one of the largest costs investors pay year-in and year-out. A carefully curated portfolio focusing on tax management could be in the best interest of many taxable investors no matter their risk profile.
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MORGNINGSTAR CATEGORIES
U.S. Equity: US Fund Large Blend, US Fund Large Value, US Fund Large Growth, US Fund Mid-Cap Blend, US Fund Mid-Cap Value, US Fund Mid-Cap Growth, US Fund Small Blend, US Fund Small Value, US Fund Small Growth
Fixed Income (Taxable Bond): US Fund Long Government, US Fund Intermediate Government, US Fund Short Government, US Fund Inflation-Protected Bond, US Fund Long-Term Bond, US Fund Intermediate-Term Bond, US Fund Short-Term Bond, US Fund Ultrashort Bond, US Fund Bank Loan, US Fund Stable Value, US Fund Corporate Bond, US Fund Preferred Stock, US Fund High-Yield Bond, US Fund Multisector Bond, US Fund World Bond, US Fund Emerging Markets Bond, US Fund Emerging-Markets Local-Currency Bond, US Fund Nontraditional Bond.
International Equity: US Fund China Region, US Fund Diversified Emerging Markets, US Fund Diversified Pacific/Asia, US Fund Europe Stock, US Fund Foreign Large Blend, US Fund Foreign Large Growth, US Fund Foreign Large Value, US Fund Foreign Small/Mid Blend, US Fund Foreign Small/Mid Growth, US Fund Foreign Small/Mid Value, US Fund India Equity, US Fund Japan Stock, US Fund Latin America Stock, US Fund Miscellaneous Region, US Fund Pacific/Asia ex-Japan Stock, US Fund World Large Stock, US Fund World Small/Mid Stock.
MORNINGSTAR CATEGORY DEFINITIONS:
Large Value: Large-value portfolios invest primarily in big U.S. companies that are less expensive or growing more slowly than other large-cap stocks. Stocks in the top 70% of the capitalization of the U.S. equity market are defined as large cap. Value is defined based on low valuations (low price ratios and high dividend yields) and slow growth (low growth rates for earnings, sales, book value, and cash flow).
Large Blend: Large-blend portfolios are fairly representative of the overall U.S. stock market in size, growth rates, and price. Stocks in the top 70% of the capitalization of the U.S. equity market are defined as large cap. The blend style is assigned to portfolios where neither growth nor value characteristics predominate. These portfolios tend to invest across the spectrum of U.S. industries, and owing to their broad exposure, the portfolios' returns are often similar to those of the S&P 500 Index.
Large Growth: Large-growth portfolios invest primarily in big U.S. companies that are projected to grow faster than other large-cap stocks. Stocks in the top 70% of the capitalization of the U.S. equity market are defined as large cap. Growth is defined based on fast growth (high growth rates for earnings, sales, book value, and cash flow) and high valuations (high price ratios and low dividend yields). Most of these portfolios focus on companies in rapidly expanding industries.
Mid-Cap Value: Some mid-cap value portfolios focus on medium-size companies while others land here because they own a mix of small-, mid-, and large-cap stocks. All look for U.S. stocks that are less expensive or growing more slowly than the market. Stocks in the middle 20% of the capitalization of the U.S. equity market are defined as mid-cap. Value is defined based on low valuations (low price ratios and high dividend yields) and slow growth (low growth rates for earnings, sales, book value, and cash flow).
Mid-Cap Blend: The typical mid-cap blend portfolio invests in U.S. stocks of various sizes and styles, giving it a middle-of the-road profile. Most shy away from high-priced growth stocks but aren't so price-conscious that they land in value territory. Stocks in the middle 20% of the capitalization of the U.S. equity market are defined as mid-cap. The blend style is assigned to portfolios where neither growth nor value characteristics predominate.
Mid-Cap Growth: Some mid-cap growth portfolios invest in stocks of all sizes, thus leading to a mid-cap profile, but others focus on midsize companies. Mid-cap growth portfolios target U.S. firms that are projected to grow faster than other mid-cap stocks, therefore commanding relatively higher prices. Stocks in the middle 20% of the capitalization of the U.S. equity market are defined as mid-cap. Growth is defined based on fast growth (high growth rates for earnings, sales, book value, and cash flow) and high valuations (high price ratios and low dividend yields).
Small Value: Small-value portfolios invest in small U.S. companies with valuations and growth rates below other small-cap peers. Stocks in the bottom 10% of the capitalization of the U.S. equity market are defined as small cap. Value is defined based on low valuations (low price ratios and high dividend yields) and slow growth (low growth rates for earnings, sales, book value, and cash flow).
Small Blend: Small-blend portfolios favor U.S. firms at the smaller end of the market-capitalization range. Some aim to own an array of value and growth stocks while others employ a discipline that leads to holdings with valuations and growth rates close to the small-cap averages. Stocks in the bottom 10% of the capitalization of the U.S. equity market are defined as small cap. The blend style is assigned to portfolios where neither growth nor value characteristics predominate.
Small Growth: Small-growth portfolios focus on faster-growing companies whose shares are at the lower end of the market-capitalization range. These portfolios tend to favor companies in up-and-coming industries or young firms in their early growth stages. Because these businesses are fast-growing and often richly valued, their stocks tend to be volatile. Stocks in the bottom 10% of the capitalization of the U.S. equity market are defined as small cap. Growth is defined based on fast growth (high growth rates for earnings, sales, book value, and cash flow) and high valuations (high price ratios and low dividend yields).
Foreign Large-Blend: Foreign large-blend portfolios invest in a variety of big international stocks. Most of these portfolios divide their assets among a dozen or more developed markets, including Japan, Britain, France, and Germany. These portfolios primarily invest in stocks that have market caps in the top 70% of each economically integrated market (such as Europe or Asia ex-Japan). The blend style is assigned to portfolios where neither growth nor value characteristics predominate. These portfolios typically will have less than 20% of assets invested in U.S. stocks.
Diversified Emerging Markets: Diversified emerging-markets portfolios tend to divide their assets among 20 or more nations, although they tend to focus on the emerging markets of Asia and Latin America rather than on those of the Middle East, Africa, or Europe. These portfolios invest predominantly in emerging market equities, but some funds also invest in both equities and fixed income investments from emerging markets.
Taxable Bond: A group of similar funds that invest primarily in fixed-income securities. Funds in the following categories are assigned to this broad asset class: Long-Term Government, Intermediate-Term Government, Short-Term Government, Long-Term Bond, Intermediate-Term Bond, Short-Term Bond, Ultrashort Bond, International Bond, High Yield Bond, Emerging Markets Bond and Multisector Bond.
World Large-Stock Blend: World large-stock blend portfolios invest in a variety of international stocks and typically skew towards large caps that are fairly representative of the global stock market in size, growth rates, and price. World large stock blend portfolios have few geographical limitations. It is common for these portfolios to invest the majority of their assets in developed markets, with the remainder divided among the globe's emerging markets. These portfolios are not significantly overweight U.S. equity exposure relative to the Morningstar Global Market Index and maintain at least a 20% absolute U.S. exposure.
Muni National Intermediate: Muni national intermediate portfolios invest in bonds issued by various state and local governments to fund public projects. The income from these bonds is generally free from federal taxes. To lower risk, these portfolios spread their assets across many states and sectors. These portfolios have durations of 4.0 to 6.0 years (or average maturities of five to 12 years).
High-Yield Muni: High-Yield Muni portfolios typically invest a substantial portion of assets in high-income municipal securities that are not rated or that are rated at the level of or below BBB (considered high-yield within the municipal-bond industry) by a major ratings agency such as Standard & Poor's or Moody's.
Russell Investments Financial Services, LLC, member FINRA, part of Russell Investments.
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