Understanding Return of Capital: How It Could Be Beneficial in a Targeted Payment Fund
- Return of capital (ROC) is a distribution from an investment that is not classified, for tax purposes, as net investment income or capital gains
- Returned capital is not taxed at the time of receipt; rather, it is subtracted from the investment’s cost basis. This postpones taxation until the investment is sold, at which time the ROC may result in a larger capital gain or smaller capital loss. Embedded gains may not be taxed, however, if the investment is never sold by the original purchaser
- At Voya, we are not particularly concerned about ROC as long as our portfolios earn a return that is greater than their distribution rate
When an investor receives a ROC, the capital being returned comes from the original investment (principal) plus the growth of the investment (unrealized gains). We think of ROC in two ways, favorable and unfavorable. If there is no growth in the portfolio, the ROC distribution consists entirely of principal, which is unfavorable ROC. If the growth of the investment is greater than or equal to the ROC, the payment reflects an unrealized gain and we consider it favorable. Take these simple examples1:
ROC with No Fund Gain
An investor buys a fund at a price of $10.00 (Figure 1). The fund returns 0% over the following year, earns no interest or dividends and realizes no capital gains, but makes a payment of $1.00. This entire payment will be classified as ROC and represents a return of principal (unfavorable ROC). As a result, the fund’s NAV and cost basis are both reduced by $1.00 to $9.00. If the investment is sold, there will be no tax liability.
ROC Comprises Entire Fund Gain
In a similar situation, an investor buys a fund at a price of $10.00 (Figure 2). The fund earns no interest or dividends and recognizes no capital gains, but over the course of the year experiences price appreciation of 10%, pushing the NAV up to $11.00. If it distributes $1.00, the entire distribution will be classified as (favorable) ROC. However, because the fund’s NAV rose 10%, the payment didn’t eat into principal. The investor now has $1.00 in his pocket, the fund’s NAV is now back to $10.00 ($11.00 minus $1.00 distribution), and the cost basis has been reduced by the distribution amount to $9.00, effectively deferring the realization of the capital gain for the investor.2
Distribution with Mixed Sources
In Figure 3, the fund again returns 10% and pays out $1.00, but 25% of the payment is net investment income, 25% is long-term capital gains, and 50% is (favorable) ROC. The NAV is reduced by the payment amount, $1.00, and the cost basis is adjusted lower by the $0.50 of ROC. An investor who receives this payment must pay taxes on the income and capital gains portions in the current year, whereas the ROC portion is not taxable.
In Figures 2 and 3 a 10% total return was achieved. In Figure 2, the entire distribution was ROC, so an investor would not need to pay any taxes in the current year, resulting in a 10% after-tax return for that year. The difference is that in Figure 3, an investor in the 33% marginal income tax bracket would be required to pay $0.12 of taxes per share, resulting in an 8.8% after-tax return.3 Of course, Uncle Sam will require the investor in Figure 2 to pay taxes on any realized gain if and when the position is sold. These gains would be taxed at the prevailing capital gains tax rate at the time of sale.
Much of investors’ distaste for ROC stems from the misconception that all ROC is simply a return of the original investment minus fees. As we have shown in the examples above, however, there are times when ROC actually can be favorable to the shareholder. What really matters is the relationship between total return and distribution yield over the investment’s holding period. Figure 4 illustrates a simple if-then framework which can provide a rough estimate of favorable versus unfavorable ROC.4
When evaluating an investment using this framework, it is important to take the investor’s objectives and holding period into account. Performing this simple analysis in isolation over a one- or two-year window, when the objective is long term, could result in conclusions distorted by systemic events or market timing; and ultimately lead to poor investment decisions, e.g., selling at a market bottom because ROC has been entirely principal over the first year when the economy was in recession and equity market returns across the board were negative.
ROC and Planning Opportunities
While ROC is not taxed in the current year, it doesn’t necessarily eliminate the liability, if there is one. With proper planning and execution, however, unrealized capital gains may escape taxation; for example, if the investor gifts the investment to charity or leaves it behind in her estate.
As a retirement income fund designed to deliver a sustainable payment stream (which often includes some ROC) without eroding NAV, the Voya Global Target Payment Fund may be an appropriate candidate for investors looking to take advantage of such planning opportunities. If the Fund is used as intended and held throughout retirement until the end of one’s life, then capital gains accumulated to that point may not be realized, since the position’s cost basis potentially could be stepped-up for the beneficiaries as of the original investor’s date of death.5,6 (Thereafter, any gains or tax liabilities would accrue to the beneficiaries.)
Even if an investor doesn’t expect to have excess assets at the end of his life, a divestment strategy could be structured to draw on lowbasis assets in taxable accounts last, given that life expectancy is never certain. Should an investor pass away earlier than expected, the heirs would receive more wealth than if the investor elected to sell the low-basis assets first, all else equal. Should an investor need to liquidate her entire investment portfolio to fund retirement needs, a tax liability would be created from the realization of any capital gains on low-basis assets. As retirement and the spending strategy progress, investors and their advisors might find it appropriate to hold, until the end, a structured payment vehicle such as the Voya Global Target Payment Fund (GTP). Funds such as GTP may offer the potential to transfer low-cost-basis assets to heirs. In addition, GTP’s globally diversified portfolio potentially can help investors avoid over-concentration in specific asset classes, as well as potentially mitigating the idiosyncratic risks associated with holding individual stocks or bonds.
1 - These are hypothetical examples used for illustrative purposes only.
2 - Cash is generated to meet this ROC distribution in one of two ways. First, any gains realized at the fund level by selling investments to raise cash are offset by realizing an equivalent or greater amount of losses on other investments in the portfolio. Second, because open-ended mutual funds have the ability to issue an unlimited number of shares, a fund can issue new shares and, if timing permits, use the inflows to meet the distribution before investing the cash. It’s also important to note that when investors elect to reinvest their distributions, cash doesn’t need to be raised. Instead, the fund simply issues new shares equal to the reinvestment amount.
3 - This assumes the investment is held in a taxable account.
4 - This framework will provide an estimate only. The actual composition of ROC will vary based on the timing of the distributions and the price of the underlying investments at the time of the distributions.
5 - When a position’s cost basis is reduced to zero, any distribution classified as a return of capital thereafter will be taxed as a long-term capital gain.
6 - The tax effects of returns of capital may differ for each individual. Investors should consult with a qualified tax advisor to make the best decisions about the treatment of investment distributions.
Past performance does not guarantee future results.
Voya IM does not provide tax or legal advice. This information should not be used as a basis for legal and/or tax advice. In any specific case, the parties involved should seek the guidance and advice of their own legal and tax counsel.
All investing involves risks of fluctuating prices and the uncertainties of rates of return and yield inherent in investing. Foreign investing does pose special risks including currency fluctuation, economic and political risks not found in investments that are solely domestic. Emerging market stocks may be especially volatile. Stock of an issuer in the Fund’s portfolio may decline in price if the issuer fails to make anticipated dividend payments because, among other reasons, the issuer of the security experiences a decline in its financial condition. Securities of small- and mid-sized companies may entail greater price volatility and less liquidity than investing in stocks of larger companies. Other risks of the Fund include but are not limited to: convertible securities risks; market trends risks; other investment companies’ risks; price volatility risks; inability to sell securities risks; and securities lending risks. Investors should consult the Fund’s Prospectus and statement of additional information for a more detailed discussion of the Fund’s risks.
Risks specific to Managed Payment:
The Fund is expected to make monthly payments under its Managed Payment Policy regardless of the Fund’s investment performance. Because these payments will be made from Fund assets, the Fund’s monthly payments may reduce the amount of assets available for investment by the Fund. It is possible for the Fund to suffer substantial investment losses and simultaneously experience additional asset reductions as a result of its payments to shareholders under the Managed Payment Policy. The Fund may, under its Managed Payment Policy, return capital to shareholders which will decrease their costs basis in the Fund and will affect the amount of any capital gain or loss that shareholders realize when selling or exchanging their Fund shares.
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