The Best Tax-Efficient Funds - Part II

Includes: EXG
by: Alpha Gen Capital

This is the second in what we are now making a bi-monthly series of reports that look at after-tax yield.

We will be launching a tax sensitive portfolio / list for members to use in their non-qualified accounts.

We take a closer look at EXG.

This report was issued to our marketplace members at Yield Hunting on April 22.

This is the second in a series of reports looking at yield that comes from the most tax-efficient sources. After all, the saying goes, it's not what you make, it's what you keep.

Asset location is very important when constructing a portfolio. In an ideal world, we would place our equities, munis and other favorably-taxed funds into our non-qualified bucket while placing our bonds and other securities that pay taxable interest at ordinary income into our qualified buckets.

The May monthly newsletter will be primarily driven toward asset location and structuring portfolios for tax efficiency.

In our first report, we discussed what a qualified dividend was and how the lower rate can be helpful for investors. The most significant difference is that non-qualified dividends are taxed at ordinary income rates, while qualified dividends receive more favorable tax treatment by being taxed at capital gains rates.

Today, we will discuss rule 199A.

From the Journal of Accountancy:

Sec. 199A was enacted on Dec. 22, 2017, as part of the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97. It provides a deduction of up to 20% of income from a domestic trade or business operated as a sole proprietorship or through a partnership or S corporation, trust, or estate, for tax years beginning after Dec. 31, 2017, and ending before Jan. 1, 2026. The Sec. 199A deduction replaces the now-repealed Sec. 199 domestic production activities deduction.

The new deduction was enacted to provide tax relief to small businesses that do not operate as C corporations, because C corporation tax rates were significantly reduced under the TCJA, from graduated rates with a top rate of 35% to a flat rate of 21%. Unlike the qualified business income (QBI) deduction, the corporate rate change is permanent, and the TCJA also eliminated the alternative minimum tax (AMT) for corporations (TCJA §§13001 and 12001; see also Notice 2018-38).

Under the statute, taxpayers who earn below $315K for joint returns and $157K for single filers may qualify for a full deduction. It is available as:

  1. The lesser of (A) the taxpayer’s “combined qualified business income amount” or (B) 20 percent of the excess of the taxpayer’s taxable income for the taxable year over any net capital gain plus the aggregate amount of qualified cooperative dividends, plus
  2. The lesser of (A) 20 percent of the aggregate amount of the qualified cooperative dividends of the taxpayer for the taxable year or (B) the taxpayer’s taxable income (reduced by the net capital gain).

This Forbes article has more information on it.

Closed-End Funds

Many closed-end funds pay qualified distributions on a portion or in some cases all of their annual dividends. We went through and sorted funds by the amount of qualified dividend income ("QDI") that they paid in the last year and the last three years.

It obviously makes sense to hold these in the non-qualified bucket given the favorable tax treatment though individual circumstances may be different. In most cases, investors have "limited" space available in their IRAs and tax deferred accounts. Thus, it makes sense to carry the most tax inefficient securities in those accounts.

Most of the top funds on the list are master limited partnership ("MLP") funds, preferred stock funds, and some tax advantaged global equity funds. On the latter, one of the criteria for portfolio managers selecting securities is to find opportunities in stocks that pay that qualified dividend. I'm a little hesitant on those funds simply because the qualified dividend universe is not that large so they are limiting their opportunity set. Second, the holding period may be restricting them from selling in order to reach that 60-day time threshold.

How To Read The Tables

The headers are a bit confusing so I wanted to go through them briefly to help make the lists more useful.

Discount/Premium: The fund's current discount or premium as of the close of business

% QDI Last Year: The % of the distribution that is classified as qualified dividend income

% QDI Last 3 Years: The % of the distribution that is classified as qualified dividend income for the last 3 years, on average.

Distribution % Income - 1yr: The percentage of the distribution that's classified as income (whether ordinary income or qualified dividend income).

Distribution S-T Cap Gain - 1yr: The percentage of the distribution that is classified as short-term capital gain. Typically ordinary income rates.

Distribution L-T Cap Gain- 1yr: The percentage of the distribution that is classified as long-term capital gain rates. 15% or 20%.

Distribution RoC one-year: The percentage of the distribution that is classified as a return of capital (basis) and is thus, not taxable in most cases.

Highest QDI - Most Tax-Efficient

Below are the top funds sorted by one-year QDI down to 50%. In other words, these are the funds that paid at least 50% QDI in the last year. The second column shows the three-year percentage when available.

Lowest Distribution % Income In The Last Year

This is the CEF universe sorted by the lowest percentage of the distribution that is classified as 'income' and possibly subject to ordinary rates. We included the yield and one-year z-score for comparison purposes.

Highest RoC % of Distribution

These are the funds that had the largest percentage of the distribution in the last year that was comprised of return of capital or basis. We also included the total distribution yield column. Remember, in most cases, RoC is not taxable. Many of these funds are in the natural resource sector including Master Limited Partnerships.

Comparing Two Funds For After-Tax Example

So how does one use this data?

Remember the old adage we quoted earlier that it's not what you make it's what you keep. After-tax returns are extremely important. Let's walk through an example.

We have two funds below (they are made up though loosely based on a couple of real like example). Fund ABC trades at a 11.25% discount and pays a 8.5% distribution yield. 100% of that yield is classified as income (think PCI as a good example). For someone in the 32% tax bracket (married filing jointly $321K - $408K) the reduction in yield can be significant.

Fund ABC which has an 8.5% yield, pays 100% as ordinary income, has an after-tax yield of 5.78%.

Fund DEF, which has a yield that is 100 bps low at 7.5%, same discount and tax rate applied, has an after-tax yield of 6.38% or about 60 bps greater than fund ABC. The makeup of that distribution consists of 15% income of which all 15% is qualified dividend income. The fund also paid 15% of the distribution as a long-term capital gain and the remaining 70% was classified as return of capital.

Now, this analysis does in no way incorporate the sustainability of the distribution. Fund DEF could be paying that large RoC amount simply because the fund is failing to generate enough net investment income. In other cases, it may be a slightly different strategy that produces the RoC.

Concluding Thoughts

Understand the taxation associated with the distribution is very important in terms of saving on taxes. Future returns are likely to be lower than in prior decades, meaning reducing tax burden is going to be an important driver of after-tax future returns. Some simple strategies can help reduce tax liability and we will cover more about that in the May letter.

Obviously, each investor is so different so some work is needed by individuals to ascertain what type of distribution they should look for and what CEF to purchase. Our tax deferred vehicles (IRAs, 401Ks, deferred comp, etc) are only so large. It makes sense to place has much of the ordinary income generators (like taxable fixed income CEFs) in those buckets. Anything that pays a qualified div, no div at all, return of capital, or some sort of blend of the various types should first go to the non-qualified (taxable) accounts.

A good example is EV Tax-Managed Global Equity Fund (EXG) which cut the distribution back in January. In reality, the investor shouldn't care about the distribution cut simply because an equity fund is not going to come close to producing net investment income to cover the 8.9% distribution. A ~9% distribution for a fund that holds about 93 equity names while writing call options on several equity indices. A fund with that investment strategy is not going to be able to produce a 9% income stream just from those activities. They are going to have to rely at least somewhat on market appreciation of the underlying holdings to fund that distribution.

The cut to EXG on Jan. 1 was not a surprise given the fourth quarter performance results of the market. The fund's NAV fell by 13.4% in the last three months of the year. A rightsizing of the distribution was a necessity at that point.

Trailing NAV and distribution yield are the best indicators for pending distribution cuts in funds with these types of managed distribution policies.

We also provided a spreadsheet to members that have a list of funds that have less than 50% of their distribution coming from "ordinary income" sources. Members can "make a copy" to manipulate it as they see fit.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.