While the equity markets have been sharply lower through June of 2022, it’s likely that actively managed mutual funds have increased their turnover ratios from normal levels. Active mutual fund portfolio managers in normal years often have turnover ratios of 50 – 60%.1 Funds with a higher portfolio turnover ratio are more likely to incur higher capital gains taxes. While the fund’s returns may be negative for 2022, the increased capital gains can create additional phantom income. Phantom income refers to a situation whereby a client owes capital gain taxes even though the investor’s general investment portfolio might have declined in value. While having a declining account with phantom capital gain income is seldom considered positive, there is a strategy that can help offset the income – Tax Harvesting.
ESI Illuminations has a strategy for its mutual fund portfolios that can allow investors to realize capital losses to potentially offset the increased capital gains, while not moving to cash and missing potential upswings in the market. The strategy is referred to Harvesting Gains and Losses. Here is an outline of the process:
- Identify clients in mutual fund portfolios within Illuminations that may potentially benefit from harvesting losses. You can do this by clicking on the Gain/Loss report under the Practice Tab, and then Book of Business Reports in ESI Illuminations. (Please note that the data in the Gains/Losses report relies on the data received by the custodian, is based on previous business day’s close, and does not update intraday unlike Wealthscape.)
- Identify whether the losses you wish to harvest are short and/or long term. (Please note that Unrealized Losses and Available Unrealized Losses can and will differ based on model IP rules, model variance limits, trade value minimum, security, and wash sale restrictions.)
- To avoid Wash Sale restrictions, request to select a replacement ETF, (The wash-sale rule prohibits selling an investment for a loss and replacing it with the same or a “substantially identical” investment 30 days before or after the sale. True “wash sales” may not be permitted by the IRS, which could translate into higher capital gains than expected. Often times, the manager has NOT identified an alternate ETF and as such, none is available –proceeds from a loss harvest will be held in cash in this event and will be reinvested back into the target model security after the wash sale period expires)
- Submit the request via the Clients’ Service Tab in the Illuminations platform to the ESI Service Request team.
- You can monitor the progress of the service request by going to the Practice tab to pull up the list of service requests. From there you can click on the Service tab to see an overview of the request and the status of each task.”
Many mutual fund investors have experienced challenging returns to this point in 2022. Adding value to clients by providing tax harvesting services through Illuminations may be of interest to many of those investors. If you have additional questions about this opportunity, please contact ESI Business Development or Advisory Operations at 800-344-7437.
- Michael Laske, Research Manager at Morningstar, Feb. 28, 2019.
TC127801(0722)1