By Jack N., FocusShares Communications Analyst and Blog Contributor
Do taxes make your eyes glaze over? Well knock back some coffee or take your daily wake-up supplement and pay attention. When it comes to investments, taxes matter – especially capital gains taxes.
Yes, I believe in paying my fair share, but I believe even more in smart investment tactics that leave more in my pocket and less in Uncle Sam’s.
And, that leads me to exchange-traded funds (ETFs), which claim to be tax efficient. If you’ve heard that, you might be wondering: “Is that really true, and what does it mean to me?”
Well, it’s mostly true. In your search for tax efficiency, ETFs – and many mutual funds – can be a good starting point.
Unexpected Tax Burden
One advantage of mutual funds and ETFs is they offer diversification within a single product. Yet when mutual funds are constantly buying and selling securities, they generate gains that are passed on to shareholders through cash distributions. Mutual fund shareholders have long groused about these distributions because they have no control over them. Plus, the size and frequency of the distributions are difficult to predict.
Even if you didn’t sell any shares, you could still end up paying a federal capital gains tax, which can really hurt your portfolio’s performance. Here’s a hypothetical example. You own 2,000 shares of mutual fund X in a taxable account, which pays a distribution of 50 cents a share for a gain of $1,000. That could trigger a federal capital gains tax of $150 for anyone in the 25 percent tax bracket or higher. And, in some states, you’ll have to tack on a state capital gains tax.
A Less Taxing Remedy
Fortunately, there’s a partial remedy. Most ETFs, along with a growing group of mutual funds, do very little buying and selling of securities, so they don’t generate gains. Instead, they buy and hold the securities in benchmark indexes, like the S&P 500.
One way to gauge a fund’s tax efficiency is to look at its portfolio turnover rate. A lower rate can result in less potential for a capital gains distribution.
Beware of Taxing ETFs
Not all ETFs are equally tax efficient. It can depend on the type of ETF. For reasons that probably are more complex than I need to share here, bond ETFs and ETFs that invest in futures contracts are more likely to pay distributions than stock ETFs. According to recent research by Morningstar, the vast majority of U.S. stock ETFs have never paid a capital gains distribution. This group includes all 15 Focus™ Morningstar ETFs, which did not pay a capital gains distribution in 2011.
Morningstar also found that ETFs were more tax efficient in general than all mutual funds (including index mutual funds) because of the unique way ETF shares are created and redeemed. I’ll be honest, I could go into great detail about this process and probably bore you to death. Bottom line: Many ETF managers can effectively trade securities without generating capital gains.
What steps do you take to improve the tax efficiency of your portfolio?
Next month, we’ll look at some of the hidden costs of ETFs.
Jack N. has been with Scottrade since 2011. He is responsible for public relations for FocusShares.
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