Executive summary:
- Tax-managed investing can help reduce the bite that taxes take out of a portfolio
- Investment taxes are triggered by different types of gains and distributions
- Tax-managed mutual funds are designed to minimize taxable distributions
There are many buzzwords and phrases in our industry and one of the most commonly used over the past few years has been "tax managed." It's quite likely you've seen that phrase in our blogs and on our website: At Russell Investments we strongly believe that no one should pay more taxes than they need to. And we equally strongly believe that a major component of an advisor's value comes from their efforts to help their clients minimize the taxes they pay on their investments.
After all, as we've noted time and time again: It's not what you make, it's what you get to keep. That's where the "tax managed" aspect comes in. Managing for taxes throughout the investment process can reduce the taxes payable on a portfolio, thereby theoretically leaving more money available to grow and compound. You can probably intuitively understand the concept of "tax managed." But what does it really mean?
Read on as we dig into the nuts and bolts of tax-managed investing, define a tax-managed mutual fund, and describe how Russell Investments approaches tax-managed investing.
How are mutual funds taxed?
Taxes have a nasty habit of eating away at investment portfolios. If you aren't careful, a meaningful amount of return can be lost just due to the impact of taxes. But, by investing in a tax-efficient manner, you can reduce the tax bill on a portfolio and keep more of the investment returns earned.
When it comes to mutual funds held in non-qualified investment accounts, taxes can be triggered in three ways:
Dividend Distributions
Mutual fund shareholders can be taxed on a fund's dividends, even if they are received as cash or reinvested in additional shares. Dividends are generally classified as either qualified and subject to capital gains tax rates or non-qualified and subject to ordinary income tax rates.
Embedded Gains That are Distributed Each Year
Inside of the mutual fund, when the fund sells stocks or bonds that have a gain, that gain must be passed along to all shareholders of the fund. Even if all the capital gains and dividends are reinvested, this can still result in a tax bill. The investor will still receive a Form 1099-DIV that shows the amount of the gain, which will have to be reported on their tax return and triggers a tax bill.
Most funds distribute these types of internal capital gains near the end of the year. This means with most mutual funds, there are some capital gains to report each year even if no shares of the fund were sold.
Capital Gains Upon the Sale of Shares of the Fund
Mutual funds are similar to stocks in that the investor is a shareholder. Normally, when an investor sells shares of a mutual fund, they will be taxed on any gains made during the holding period. When shares of a mutual fund are sold for more than was paid for them, that will result in either a short-term capital gain if owned for one year or less, or a long-term capital gain if held for longer than one year. Selling your mutual fund shares is in your control.
What can be done to minimize these taxes?
This is an easy one to answer! Consider investing in tax-managed mutual funds. Tax-managed mutual funds can make a lot of sense for investors in taxable accounts--provided they live up to their promise of being tax-efficient.
While most traditional mutual funds are not managed with the impact of these capital gain distributions in mind, a tax-managed mutual fund can take steps to significantly reduce – or even eliminate – these unwanted distributions. By eliminating the prospect of unexpected distributions, shareholders of tax-managed mutual funds have control over the tax year in which capital gains are reported. For example, they can choose to sell their shares of the fund in a year when they may have less income from other sources.
Tax-managed mutual funds are designed to generate returns via fund price increases, while avoiding annual capital gain distributions.
They not only have investment objectives to provide returns similar to non-tax managed funds, but tax-managed mutual funds also have an obligation to minimize taxable transactions within the fund itself. They do this in several ways, whether by selling some stocks at a loss to offset other gains, eliminating wash sales, scrutinizing tax lots, evaluating dividend-paying stocks, or by holding on to stocks rather than selling.
How does Russell Investments approach tax-managed investing?
Russell Investments employs all the principles of tax-managed investing such as year-round tax loss harvesting, paying attention to holding periods, reducing turnover, eliminating wash sales, deferring realized gains, and strategically managing tax lots.
Our trading desk then enhances tax efficiency by employing an internal overlay management team to coordinate trading activity across all the underlying money managers within each tax-managed mutual fund. With total portfolio management ("TPM"), all the securities within each Fund are held in a single custody account, where they are fully monitored and solely transacted by the overlay management team. Considerable tax benefits can be derived using this TPM approach. For example, when one money manager is buying a position and another is selling the same position, the total transaction can be lessened because all or part of the buyer's purchase can be fulfilled by the seller, with potentially no actual transaction required within the overall fund.
This additional layer of coordination and centralized oversight has enabled Russell Investments to deliver a consistent history of low to no capital gain distributions within its lineup of tax-managed mutual funds.
We're not only leaders in active tax management, we're also pioneers, having spent more than 35 years sharpening an approach tailored to remove complexity, solve problems and save time. We are here to serve advisors looking to unlock true return by helping their tax-sensitive clients keep more of what they earn.
Next: Key differences between tax-managed mutual funds and ordinary mutual funds.