More opportunities to harvest losses
A significant difference between separately managed accounts (SMAs) and mutual funds or exchange-traded funds (ETFs) is that an SMA investor owns the underlying securities within the portfolio instead of units or shares of a pooled vehicle that represent an investment in the underlying holdings. This difference is key to one of the main tax advantages offered by SMAs: the ability to offset taxable gains by harvesting losses in these individual securities.
While mutual fund and ETF investors can benefit from tax-loss harvesting, this benefit is only available at the fund level. The mutual fund or ETF investor’s adjusted cost base (ACB) needs to be greater than their fair market value in order to realize a capital loss when they sell. SMA investors, however, can potentially benefit from tax loss harvesting on a security-by-security basis, even if their overall portfolio return for the year is positive.
To illustrate this point, consider a hypothetical SMA that holds five securities.
This hypothetical SMA strategy has gained 2.2% for the year. If this was a mutual fund or ETF, this would represent the fund’s return for the year. If an investor purchased the mutual fund or ETF at the beginning of the year and sold at the end of the year, they would have a capital gain rather than a capital loss.
In contrast, investors in an SMA would be able to sell securities C and E (not just the entire portfolio) and use the capital losses to offset other realized capital gains, reducing their overall tax liability. If they wanted to re-acquire securities C and E, the SMA manager would be able to repurchase them after 31 days, thereby avoiding the superficial loss rule. Otherwise, rather than offsetting realized capital gains and saving tax, the capital loss would be added to the ACB of the identical security that’s repurchased.
No embedded capital gains for SMAs
Another tax advantage of SMAs is that investors within these vehicles aren’t subject to embedded capital gains. This differs from a mutual fund, where the cost basis of the underlying securities doesn’t necessarily reflect the security’s price on the day an investor purchases units or shares of the mutual fund. This mismatch can create the potential for a scenario in which there’s a tax liability when the portfolio manager sells an underlying security, but the end investor hasn’t sold their units or shares, leading to a taxable distribution.
The 2022 calendar year was a reminder that mutual funds can still distribute capital gains in down markets. Certain scenarios, such as a period of net outflows sparked by negative performance, can force portfolio managers to sell appreciated stock positions to meet investor redemptions. This can increase the likelihood of capital gains distributions for all investors, even those who haven’t sold their position or made any money on their investment.
With SMAs, there are no embedded capital gains to worry about. Since the underlying securities are purchased directly, end investors will only pay taxes on gains related to their account and not those of other investors, making SMAs a more tax-efficient vehicle.
Greater control over your tax bill
Finally, SMAs can potentially provide investors with a higher degree of control over their tax bill. Since investors are working directly with the asset manager, they can deploy several strategies to limit their tax liability in any given year.
As an example, investors looking to switch from one SMA to another might transition into the new strategy over time, spreading taxable gains over more than one calendar year. If there are overlapping securities between the two strategies, these holdings can be transitioned in kind rather than being sold, avoiding a taxable event.
Furthermore, investors in SMAs pay a set management fee quarterly or annually and they may be able to deduct that fee on their income tax returns. By comparison, mutual funds have an embedded management expense ratio (MER) which is deducted by the fund, not the investor. Instead, these MERs reduce the income that can be distributed, which reduces the amount that’s taxable to those investors.
Some high-net-worth investors might even want to consider their SMA holdings as a funding source for charitable giving. By identifying securities that have appreciated well above their ACB, investors can donate these holdings directly to a qualified charity, avoiding capital gains tax. The donation would provide the investor with a generous tax credit, helping to further reduce their tax liability. As every financial situation is unique, SMA investors should consult with their tax advisor and a financial professional to help identify the best way to limit their tax liability.
Choosing an SMA for your portfolio
The tax-friendly nature of SMAs can have a sizable benefit on portfolios over time, but it's important to note that they may not be suitable for everyone and are generally reserved for accredited investors only. Investors that are able to access SMAs will often combine them with ETFs and mutual funds, constructing their portfolio with a full understanding of the advantages and disadvantages of each investment vehicle.
As we near the end of the year, a time when many mutual funds are likely to distribute capital gains, this could be a good time for investors in taxable accounts to reassess whether a tax-efficient vehicle like an SMA might be the right choice for their portfolio.
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