It seems that every year in December we get a multitude of calls from clients regarding a pretty common occurrence for certain types of investments.This month, most pooled investments pay out their capital gains to shareholders and the value of the associated account falls for a few days until the money is reinvested or paid out. Given the healthy returns global stock markets have experienced over the previous 12 months, many of these types of investments will be paying out larger capital gains this year. When this occurs, you may notice that the investment paying out the capital gain will decline in value by an amount equal to the capital gain to be paid. Within a few days the capital gain will be credited to the investors account. While generally speaking, a capital gain means an investor made money on an investment this is not always the case with those who have held the investment for only a short period of time.
Some of the potential benefits of pooled investments, (ie. owning a diversified, professionally managed portfolio) may sometimes result in some unintended consequences, like capital gains. Because portfolio managers are actively buying and selling throughout the year and owners investment dollars are pooled with that of other investors with different holding periods, these investments are allowed to pay out all of their capital gains to all current shareholders of record on a specific date, (typically in December). This means that an investor that just purchased the investment last week in their taxable account, could end up paying taxes on a capital gains distribution even though the value of their investment is currently flat or underwater. In essence, many investors in pooled investments end up paying taxes on gains even though they were not along to enjoy the ride.
Let’s examine a scenario showing how this could unfold in a hypothetical investor's account. Art Vandelay has decided he wants to diversify some of his personal assets outside of his importing/exporting business by investing $100,000 in his taxable brokerage account into the ABC Flagship Portfolio. When he purchases his shares on December 10th, they are valued at $10.00/share and he is able to buy 10,000 shares. Due to some highly appreciated securities that were sold by ABC Flagship's portfolio manager earlier that year, it is paying out 10% of its value in the form of a capital gain on December 15th. At the market close on the 15th and assuming no change in the market value over the 5 days since his original purchase, Art will have 10,000 shares valued at $9.00/share. On the following day, a capital gain of $1.00 per share will be paid back into his account for a total of $10,000 (often this is just reinvested back into the pooled investment). Now while Art’s portfolio value is still no larger on the 15th than what is was on the 10th, he will owe Uncle Sam taxes on this capital gain payment of $10,000 at his capital gains rate of 15%. This would be quite discouraging for Art to pay $1500 in taxes even though he has yet to make a profit on his investment!
What to do now?
Because of the potential tax implications, we believe it is important to review your current tax situation and portfolio prior to year end. If you are getting cash to work, it also may be advantageous to purchase pooled investments that are paying out large gains after their payable date by waiting an extra day or two. It is also important to note, that while this doesn’t impact the taxation of these types of investments held inside of retirement accounts like IRA’s and Roth IRA’s, some clients may notice that the value of their accounts will show a large fluctuation the day prior to the capital gain being paid into their account as the funds share price drops by an amount equal to the capital gain being paid out. This is more noticeable in years when many funds are paying out large capital gains.
For many clients with taxable acccounts we have been shifting to passive models invested in index-based pooled investments that typically have lower turnover and may be subject to lower capital gains. If you are in a higher tax bracket and have significant funds invested outside of retirement accounts, reviewing this may be warranted.
From a pure investment perspective, there are many potential benefits to owning pooled investments including having a diversified, professionally managed portfolio as well as the ease to which they can be purchased. Just as with any financial matter though, it is important to consider the impact of ownership from multiple angles including taxation. Before making any investment, you should review the prospectus as well as consult with a qualified financial professional to examine the ramifications to your overall situation. If you would like to get more details on which investments within your portfolios are subject to large capital gain distributions, please let us know. We have prepared a report on all holdings within these models. Investors can also access some of this by pulling up their individual holdings on Morningstar.com.
Nick Hughes is a Wealth Advisor with Franklin Wealth Management, a registered investment advisory firm in Hixson, Tennessee. In addition to advising clients since 2007, he has contributed to articles for Market Watch and FinancialPlanning.com and is a regular contributor to the Franklin Backstage Pass blog.
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