Strategic Tax Planning for Mutual Fund Distributions

Understanding tax implications within a portfolio allows Aldrich Wealth to make informed decisions about asset allocation, timing of sales, and selection of investments. This approach aims to develop effective strategies that help optimize after-tax returns for our clients. One tax-saving opportunity we monitor at year-end is the capital gain distributions rolled off mutual funds.

Mutual funds are a popular investment vehicle for individuals seeking diversified portfolios, allowing investors to spread their funds across various assets such as stocks, bonds, and other securities. Most mutual funds are actively managed, meaning the fund aims to outperform the market compared to a specific benchmark. Instead of an investor buying and selling individual equities and bonds themselves, professional fund managers use pooled funds from multiple investors to strategically allocate the assets based on the fund’s investment objective. The expertise of fund managers allows individual investors to benefit from professional analysis and decision making without having to manage their investments directly.

Mutual funds are required by law to distribute nearly all their income and realized capital gains to investors. Thus, the funds themselves do not retain the income they generate, but instead, periodically distribute income in the form of dividends or capital gain distributions. Throughout the year, mutual fund managers buy and sell securities within their portfolios according to the strategy in place. When an asset is sold for more than its original purchase price, this profit is known as a capital gain. Over the course of a year, if a fund realizes a significant amount of capital gains, it will distribute a portion to shareholders, typically towards the end of the year. The gains can either come as short-term, securities held for less than a year and taxed as ordinary income rates, or long-term, securities held more than a year and taxed at capital gain rates. The fund holder is responsible for the tax on the gain even if they didn’t realize the gain personally.

When creating investment portfolios for our clients, Aldrich Wealth strategically allocate assets to the most suitable account based on tax efficiency. For example, we aim to place mutual funds that produce higher distributions in tax-advantaged accounts like IRAs when appropriate. This approach helps to alleviate the tax implications of those distributions for our clients.  As a result, if a mutual fund distributes dividends or capital gains, and those investments are held in a tax-deferred account, clients will not experience any immediate tax impact.

Additionally, we proactively communicate with fund managers to understand the expected capital gain distributions for mutual funds in our clients’ portfolios. If the client’s unrealized gain in the position is less than the expected upcoming distribution, we will sell the security before the record date to help reduce our client’s realized gain. For instance, if we anticipate a distribution will be a certain percentage of a client’s investment ($10,000) and that exceeds their total gain in the position ($6,000), we may consider selling the position beforehand. This approach helps the client avoid the impact of a larger capital gain distribution and benefit from the smaller gain.

Lastly, during the last quarter of the year, we refrain from purchasing shares of active mutual funds that are expected to pay significant distributions. This approach helps us avoid putting our clients in positions where they would immediately incur a tax liability.

By incorporating tax considerations into investment planning, Aldrich Wealth helps our clients better align their financial goals with tax obligations, supporting their overall wealth-building potential and optimizing strategies to improve their after-tax return.