How to Pay Zero Capital Gains Taxes on Fund Holdings

By MBA, CFP® - Chief Executive Officer, Vernon C. Sumnicht on June 23, 2020

During times like we recently experienced in 2008, when a strong multi-year bull market is followed by a significant market correction, investors can see the true benefits of utilizing exchange-traded fund (ETF) indexes compared to mutual fund indexes in investment portfolios. During extended bull markets when mutual fund indexes continue to go up year after year, they will have significant unrealized capital gains. When a significant market shock causes a 20% – 50% decline in the market, many investors in these index funds get scared and sell these index mutual funds, which in turn forces the index fund company to sell shares and realize capital gains to meet these redemptions. This causes the long-term buy/hold investors in these same index mutual funds to incur their pro-rata share of those realized capital gains.

Often, this situation is overlooked by advisors who are not thinking about these situations. Their expectations with index funds are that capital gains distributions will not be incurred because indexing doesn’t involve managers buying and selling, stock picking or timing the market. They expect to continue to defer realizing any capital gains for many years as long-term buy/hold investors.

Whereas ETF index managers (only dealing with distributions in kind) never need to sell (at the fund level) to meet redemptions and therefore, they don’t incur capital gains during market shocks even if 50% of shareholders sell. Only the ETF sellers realize capital gains; those who are long-term holders are not affected (tax-wise) by the sellers.

More and more advisors and clients are coming to realize this downside to indexed mutual funds relative to the advantages of index ETFs. Don’t leave your clients out on a limb. Protect their portfolio’s long-term buy/hold strategy by not letting them incur the pro-rata share of those realized capital gains. By utilizing comparable ETF indexes instead, you can eliminate these costs and thus improve your client’s long-term investment performance.

iSectors® strategies are rooted in our philosophy of asset allocation and passive index funds, rather than the selection of individual securities or market timing. Our investment process seeks to maintain low overall investment costs using ETFs and technology provided by turnkey asset management and custodial platforms. The iSectors® strategies also offer transparency, liquidity, daily pricing, holdings, tax and performance updates.  iSectors® allocation models can be held in separately or unified managed accounts, titled in the client’s name, at an independent brokerage firm.

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