As advisors, we utilize many strategies to help our clients generate higher after-tax investment returns, including security location optimization, short-term gain avoidance, and tax-managed mutual funds.
We also use another less well-known strategy called capital gain distribution avoidance (CGDA). CGDA is the act of selling a mutual fund with a high estimated year-end distribution and buying a similar fund that has a smaller estimated distribution. The mechanics are similar to tax-loss harvesting, but the fund is not being sold to generate a tax loss. The fund is being sold to avoid taxes on the capital gain distributions.
Mutual funds usually distribute dividend income every month or quarter. However, capital gains accumulate throughout the year and are generally distributed to shareholders at the end of the year. Fund companies typically announce estimated capital gain distributions in late October. Since these distributions can include qualified and non-qualified dividends, as well as short term and long-term capital gains, the tax consequences can be substantial.
There are few options for handling capital gain distributions. We can:
Take the distributions and pay the taxes;
Sell the fund prior to the distribution date, and then wait until after distributions are paid to buy it back; or
Use CGDA to reduce taxable income, while still maintaining the preferred market position.
To determine if CGDA will be beneficial, we must first find the distributing funds estimated distribution. If the distribution will be material, the next step is to locate a similar fund with a lower estimated distribution. If there is a substantial difference between the two distributions, CGDA might be appropriate.
There are a couple of complexities. Most importantly, for each client owning the distributing fund, we must make sure that the tax lots to be sold do not generate a taxable gain in excess of the CGDA benefit. Our portfolio accounting software allows us to see cost basis by tax lot, along with short-term and long-term unrealized gains. This helps us compare the tax cost of selling shares of the distributing fund vs. the taxes that will be avoided by reducing capital gain distributions. When calculating taxes, we make sure to use each individual clients respective tax rates. With the pieces of the puzzle in place, number crunching is all that remains.
Lets look at an example, shown in the table:
In the example in the table, the tax savings from CGDA will be the (Difference in Long-Term Distributions x Long-Term Capital Gain rate) plus (Difference in ShortTerm Distributions x Ordinary Tax Rate) minus (Tax on Gains Recognized).
Lets calculate. Assume that the client sells 200 shares of ABC, thus avoiding $200x ($5 – $2) = $600 in long-term distributions and 200 x ($2 – $1) = $200 in short-term distributions. The savings from this is ($600 x 20%) + ($200 x 40%) = $200. From this, subtract the tax costs of recognizing the gains on the shares of the distributing fund that was sold, which is 100 x ($12 – $11.50) = $50 long-term capital gain and 100 x ($12 – $11.60) = $40 short-term capital gain. The tax on the gains will be ($50 x 20%) + ($40 x 40%) = $26. Thus, the savings is: $200-$26= $174.
Thats a substantial benefit. Admittedly, CGDA can be labor intensive, but we use cutting edge software to execute this tedious task very efficiently.