Fund companies are publishing estimates of the capital gains they expect to distribute before year-end, and the figures vary widely from one fund to the next. Preliminary estimates from Dimensional Fund Advisors show no long-term capital gains distribution for 42 of its 54 equity mutual funds this year, while some actively managed funds pay out far more. Last November, CNBC reported that more than 10 funds were projecting 2025 payouts of at least 25% of net asset value. Investors in taxable accounts can owe tax on those distributions even if they haven’t sold a share.
For high earners, such distribution notices point to a larger planning question. Actively managed funds, taxable bond funds and REITs can generate income or capital gains distributions that create recurring tax liabilities in brokerage accounts. For clients already maximizing their retirement plan contributions, advisors have to consider where new investments belong and whether the tax cost of repositioning existing holdings is justified.
Orian Williams, JD, LL.M, CFP, a managing director at Pacific Life, puts that decision at the center of a white paper the company published in August. Writing for advisors, he frames it as a choice:
“Is it in the client’s best interest to voluntarily incur annual taxes through tax-inefficient vehicles, or is it wiser to defer and control when those taxes will occur later in life?”
Williams makes the case for advisory investment-only variable annuities as one answer. “If we combine tax deferral and asset location, we create the opportunity to defer the recognition of ordinary income to a future lower bracket,” he writes. “That opportunity depends on the client actually landing in a lower bracket. Annuity gains are taxed as ordinary income when withdrawn, and the taxable portion of most withdrawals before age 59½ carries an additional 10% federal tax. The contract also forgoes the step-up in cost basis at death, and its costs and investment options have to be weighed against any tax benefit.”
Annuities are one option among several. Plan design can let high earners save more than a standard 401(k) deferral allows, and taxable accounts can be managed with attention to when gains are realized. To learn how advisors are working through the question, I sought out insights from three industry executives:
- John Marshall, Partner, Carrick Lane, an investment manager specializing in actively traded options strategies
My questions and their responses are below. Of course, investors should consult a qualified tax professional regarding their specific situation.
Jim Roth: For high earners already maximizing their regular 401(k) contributions, what additional tax-advantaged savings options can employers build into plan design, and what keeps more sponsors from offering them?
Scott David: For a business owner, I’d consider a cash balance plan alongside the 401(k). For example, two partners at a medical practice who are in their 50s could potentially save far more than the 401(k) alone allows. For other high earners, I’d determine whether the plan supports a mega backdoor Roth strategy – after-tax contributions that are converted to a Roth. Plan sponsors often pass on both options. A cash balance plan requires ongoing employer funding, while after-tax contributions may create nondiscrimination testing challenges. That’s why advisors should involve the recordkeeper and plan administrator early before the sponsor commits to a plan design.
JR: For high-net-worth clients who have maximized their retirement plan contributions, how do you decide which investments belong in taxable accounts, and when do tax-deferred options outside those plans warrant consideration?
Jim Worden: It usually makes the most sense from a tax standpoint to put the higher risk, higher beta strategies inside a Roth IRA or Roth 401(k). If a Roth is not an option and the strategy has a lower turnover, these usually fit best in a non-qualified account, so we can take advantage of the lower long-term capital gains tax rate. For more conservative strategies that have a lot of exposure to taxable bonds, these often make more sense in a qualified account since taxable bonds would be taxed at ordinary income rates anyway. Obviously, tax-exempt fixed-income should always be in non-qualified accounts. There could be periods, however, where the yields on tax-exempt fixed-income are paying more than taxable fixed-income. In some rare cases, an investor could hold tax-exempt fixed-income inside a qualified account if they didn’t have an opportunity to hold this in a non-qualified account. The financial crisis was one of those rare periods where some asset managers found higher yields and much better value with tax-exempt fixed-income than taxable fixed-income.
JR: When adding an options overlay to a client’s existing taxable portfolio, what tax considerations should advisors weigh alongside the strategy’s investment and risk-management objectives?
John Marshall: The tax treatment of options can vary based on the type of options being utilized in an option income strategy. The income from short-term single stock options programs is typically taxed as 100% short-term capital gains, while index options mainly fall under section-1256 tax-treatment that specifies 60% long-term capital gains and 40% short-term capital gains. We advise investors to consult a tax expert for advice on their particular situation.
Jim Roth is a partner at Ascentix Partners, a network of elite strategic consulting and M&A advisory firms that specialize in accelerating value creation for wealth management enterprises.