Don’t let taxes drag you down

May 26, 2021
  • Michael Lane

This year’s extended Tax Day of May 17th is behind us, but taxes will be top of mind for financial advisors and their clients for many months to come. I’ve never been much of a forecaster, but it seems difficult to have a conversation with advisors or friends that doesn’t end in a prediction about what future tax rates will look like. 

It didn’t come as a surprise when President Biden announced a proposal that included significant tax increases to help pay for his $1.8 trillion spending plan. The increases, if enacted, could raise the tax rate for income over $400K, as well as boost the capital gains rate to the same rate as ordinary income for high earners. My colleagues have published a helpful guide that offers more detail on the proposals and what it would mean for clients.

Of course, it is impossible to know how much of this proposal will be enacted into law, given the narrow margins that Democrats hold in the House and Senate. Death and taxes may be the only certainties in life, but accurately predicting the final scope of tax proposals is not something one can do with absolute confidence.

In short, there is no need to panic, and investors should stay the course towards meeting their goals. Nevertheless, there are several reasons for advisors to focus on taxes now with clients that go beyond the recent headlines. There are concrete steps advisors can consider to minimize taxes for their clients now -- and going forward.

Lock in long-term gains. Many who invested or did tax trading in the equity market in March and April of 2020 during the COVID-19 selloff, most likely have seen significant gains. If so, now that a year has passed, those gains would be taxed at the long-term, rather than the short-term rate. Given the sharp rise in stocks over the last year and current economic and market conditions in a reopening world, those investors may want to consider adjusting their allocations while long-term capital gains rates are low.

Keep an eye out for more frequent mutual fund capital gains distributions. The financial advisors I’ve spoken to recently have mentioned an emerging trend of mutual funds distributing capital gains to their fund holders quarterly or semi-annually, rather than annually. This may be a response to the fact that investors have become savvier about selling mutual funds before gains are distributed, which traditionally has occurred in the fourth quarter. Of course, investors should evaluate the tradeoff of paying taxes on the sale of a mutual fund versus paying taxes on the distribution of a capital gain. Financial professionals can utilize BlackRock’s Tax Evaluator Tool as an easy way to track anticipated gains for funds within their clients’ portfolios and the expected dates of distributions. For those looking to maintain high correlations for investments to avoid falling victim to the wash-sale rule, the BlackRock Correlation Calculator can also help identify investments with high correlations with lower holdings overlap.

Note how taxes can have a major impact on returns. Whether taxes go up or not, they still matter for investment returns. The selling of securities by portfolio managers within funds can trigger capital gains taxes that are distributed to investors holding the funds. That can represent a surprisingly large drag on returns. For example, for the 10 years ending in 2019, taxes on distributions reduced returns on the average annual performance of actively managed U.S. Large Cap Blend mutual funds by 1.79 percentage points. Over the same period, the average expense ratio of that category was 0.89%. In other words, while investors are increasingly focused on fund fees – as they should be – the average impact of taxes has been nearly double that of the expense ratio. The fact that the tax bite was larger than the average fees was true over that period in every one of the Morningstar style boxes.1

Consider using ETFs. Mutual funds and ETFs can both pay out capital gains distributions, but the difference can be substantial. Over the past five years, 66% of equity mutual funds paid out taxable capital gains distributions, while less than 9% of equity ETFs have distributed a taxable gain.2

Of course, ETFs have other benefits, including low fees, and access to a range of asset classes that can help advisors build an asset allocation as either core or satellite holdings for their clients, potentially improving after-tax returns and demonstrating that the advisor is adding value to the client. But the growing recognition of the potential tax efficiency of ETFs goes a long way towards explaining the growing usage of ETFs in portfolios.

At BlackRock, we believe that both active mutual funds and ETFs play valuable roles in a portfolio. However, when choosing an investment vehicle, investors should consider whether they have confidence that taxes will not reduce or eliminate any potential excess returns, particularly in asset classes and funds with higher turnover.

More broadly, financial advisors and planners routinely focus on ways to manage their clients’ overall tax burdens, such as emphasizing municipal bonds as a core component of fixed income portfolios. But in my experience, many investors downplay the tax implications of the investments themselves in their portfolios. In the coming months and years, that will need to change. The emphasis on managing taxes will need to be as central to a portfolio as the asset allocation itself.