Capital gain distributions occur near year end when mutual funds need to pass through gains realized within the funds. This means shareholders have to pay tax on income they haven't received. It's true that the basis gets increased, but clients typically don't like paying taxes on phantom income.
Soon firms will begin publishing preliminary estimates of distributions. In most cases, these distributions won't be material. However, advisers should be on the lookout for large distributions from actively managed funds. Many actively managed funds have experienced outflows that have forced managers to sell appreciated securities to pay for liquidations. This triggers gains that, in turn, get spread across a smaller shareholder base.
At this point in time, several fund companies have already released estimates. In fact, there are already funds estimating distributions of higher than 20% of net asset value, including Columbia Disciplined Small Core Fund, Delaware Smid Cap Growth Fund, Columbia Acorn Fund, Dreyfus/The Boston Company Small Cap Growth Fund and Morgan Stanley Institutional Fund Trust Mid Cap Growth.
By checking estimated distributions on clients' funds, advisers can identify which, if any, will result in disproportionately high tax hits. At a minimum, advisers should warn your clients of what to expect. And, for those wanting to be a hero, steps can be taken to avoid these distributions. Absent automation, this process can be cumbersome. The process is:
1. Determine which funds estimate high capital gain distributions.
2. Select an alternate fund or ETF to substitute for the high-distributing fund prior to posting.
3. Determine which clients hold material positions in the high-distributing fund.
4. Sell and replace shares of the high-distributing fund in cases where the savings is material. This necessitates determining the savings from lowering the dividend recognition net of potential recognition of gains (or losses) on the sales.
Without automation, the best an adviser can do is to warn clients and address the largest bombshells. However, to do that, the adviser must first find the estimated dividend distribution amounts. Unfortunately, there is no central automated database for this information. At the most basic level, the adviser can research each fund company's estimates for their clients' holdings. This will involve searching each company's website.
One solution is the CapGainsValet site, which offers a way to search fund distributions in one place, rather than having to look one by one on the funds' websites. There is no charge for the “free search” option. This service provides links to capital gain distribution estimates on roughly 70% of all mutual fund assets. The “pro search” expands the database to more than 250 mutual fund families as well as the largest ETF providers. Additionally, the “pro search” includes preliminary distribution information to better support year-end planning. The cost of this service is a one-time fee of $45. My favorite part of the site is the “dog house” list — funds with estimated distributions of more than 20% of net asset value.
Although the tools for dealing with capital gain distributions are fairly low tech, advisers need to work with what's available and not let this year's distributions wreak havoc for their clients.