by Gregory Lopez, CFP®, Financial Advisor – Oswald Financial Wealth Management
When you own qualified assets like IRAs, 401(k)s and other tax deferred vehicles, the taxation of these funds is relatively straight forward. Typically, as funds are withdrawn from these type of accounts, the account owner is taxed at current income tax rates just as if it was part of a paycheck. While assets remain in these accounts, there is no tax on potential gains, dividends or interest.
People with assets outside of tax preferenced accounts like IRAs have a different tax issue/situation entirely. Gains, dividends and interest are all taxed annually to the extent they exceed losses. This leaves the account holder with big decisions to make from time to time.
What do you do with an account which has considerable gains? If you want to rebalance, is the taxable gain worth the allocation shift? Some might put off rebalancing the portfolio because the taxes due could be quite significant. Alternatively, some might view that a proper allocation should be more important than taxes paid on gains.
Although many investment options exist, we will focus on Mutual Funds as being one of the least tax efficient tools. With over half of American households owning mutual funds and 90% of those funds being actively managed (1), investors need to pay close attention to the potential tax issues they can face.
Tax Inefficiency of Mutual Funds
When looking at the 10 largest mutual funds by asset size, the turnover ratio is almost 75% (1). This means investors will pay higher taxes in the form of distributions due to mutual fund managers selling or buying 75% of the stocks that make up their fund annually. It doesn’t matter if you purchased the fund at the beginning of the year or late in the year, you are still responsible for the entire year’s taxable gains. This also means you may technically have had a loss, but paid taxes. This is referred to as embedded gains. These gains are distributed to the investor, and the fund’s net asset value (NAV) is lowered by the amount of the gain. The distribution is not, in itself, a bad deal since the investor gets their distribution. However, It may negatively affect an investor who may be not desire to pay additional taxes on gain when she was not expecting the tax bill or an investor at the top of the tax bracket where these gains become taxed at relatively high rates.
Taxes can be realized in any fund, regardless of the turnover ratio simply by redeeming shares for outgoing investors. This happens when managers are forced to sell shares of the investments in the fund to provide cash for the investor. In addition to these factors, many mutual fund managers have no mandate for tax efficiency, which may lead them to attempt to clean out any gains in the portfolio at the end of each year to minimize the buildup of large capital gains year to year. In fact, mutual fund managers are required to distribute 95% of their capital gains to shareholders. In all these tax complexities, there are alternatives for those most affected by taxes.
OPTIONS TO EASE THE TAX BURDEN
Mutual Funds with Tax Efficiency Mandates
There are mutual funds that have a mandate for tax efficiency. These funds tend to have lower yields and lower turnover. The category would be growth stocks vs less tax efficient value stocks, which pay dividends. There are mutual funds that have a mandate for tax efficiency. These funds tend to invest in companies that do not pay taxable dividends. The managers also work to offset gains throughout the year instead of just at the end of the year. This happens when a manager sells some stocks at a loss so she may sell companies at a gain with the goal of minimizing taxes while staying within an investment discipline. These mutual fund managers typically buy companies that reinvest back in the growth of the company instead of distributing dividends. Investment objectives for people buying these funds are typically growth with no income. Sales fees vary from fund to fund and management fees may apply. These funds are typically liquid and are subject to the risks of the underlying securities. No guarantees exist for these or any mutual funds as they relate to principal or returns.
Owning individual stocks may produce significantly lower tax obligations as compared to other investments including mutual funds without a tax efficacy mandate. Although some stocks produce dividends, the majority of taxable events for stocks are upon liquidation. By holding a stock longer than one year, capital gains are taxed at current long-term gains rates as opposed to ordinary income rates. In addition to this tax benefit, individual stocks passed on, after death provide a step up in basis for the person inheriting the stock, usually creating no tax gain upon inheritance. Occasionally another company acquires stock in a company whom you own and a cash buyout is unavoidable. These instances typically create a taxable gain whether you like it or not. Investment objectives for people buying stocks can range from those with a very high risk to a moderate risk tolerance. Both Growth and income can be an objective depending on the investor. Sales fees may vary and management fees may apply. Most stocks are typically liquid and are subject to market risk. No guarantees exist for stocks as they relate to principal or returns.
Separate Account Managers (SMAs)
SMAs are like mutual funds but the managers purchase each individual stock or bond for you, creating a cost basis that you can control. Unlike a mutual fund that rids themselves of built up capital gains at the end of each year, paying a taxable distribution to you, SMAs can be more sensitive to your taxable situation. There may be an opportunity to take advantage of short-term losses to offset any built up gains. Investment objectives for people buying SMAs can range from those with a very high risk to a moderate risk tolerance. Both Growth and income can be an objective depending on the investor. Typically, manager and advisor fees apply. SMAs are typically liquid and are subject to the risks of the underlying securities. No guarantees exist for SMAs as they relate to principal or returns.
The Case for ETFs
If your goal is to hold for a very long period of time, ETFs can create great diversification, low cost of ownership and minimal transactions, resulting in potentially less taxable gains than with traditional mutual funds. Taxes in ETFs are typically realized if you sell the ETF for a gain. Since ETFs do not make large amounts of transactions (2)(10% turnover on average) or sell out gains at year-end, the result is typically a significantly lower tax bill for the investor in a year of growth. Investment objectives for people buying ETFs can range from those with a very high risk to a moderate risk tolerance. Both Growth and income can be an objective depending on the investor. Sales fees vary from ETF to ETF and management fees may apply. ETFs are typically liquid and are subject to the risks of the underlying securities. No guarantees exist for ETFs as they relate to principal or returns.
If the risk tolerance of the client is currently or becomes more conservative, bonds may be used in greater amounts in an overall portfolio. With the purchase of bonds comes the option to purchase tax-free bonds. This strategy seeks to further drive down taxable income where appropriate in your portfolio. Investment objectives for people buying Fixed income is generally to produce income at a low to moderate risk. Sales fees vary within Fixed Income vehicles and management fees may apply. Fixed Income can be less liquid in some instances and is subject to market, default and liquidity risk. Some forms of bonds are guaranteed but the vast majority are not guaranteed to the extent of principal and interest.
Balance and Priorities
In the end, you must make the determination what is most important to you and your financial situation. A seasoned Certified Financial Planner or financial advisor can help you uncover your options to address the burden of taxable income. She may also help and weigh out the pros and cons of various investment tools and techniques.
Securities offered through LPL Financial, member FINRA/SIPC. Other advisory services offered through Oswald Financial, a registered investment advisor and separate entity from LPL Financial.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. We suggest that you discuss your specific situation with your financial advisor prior to investing. Contributions to 401(k)s and IRAs may be tax deductible in the contribution year, with current income tax due at withdrawal. Withdrawals prior to age 59 ½ may result in a 10% IRS penalty tax in addition to current income tax. Investing in mutual funds involves risk, including possible loss of principal. Investing in stock includes numerous specific risks including: the fluctuation of dividend, loss of principal and potential illiquidity of the investment in a falling market. The payment of dividends is not guaranteed. Companies may reduce or eliminate the payment of dividends at any given time.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price. Municipal bonds are subject to availability and change in price. They are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Interest income may be subject to the alternative minimum tax. Municipal bonds are federally tax-free but other state and local taxes may apply. If sold prior to maturity, capital gains tax could apply. An investment in ETFs involves risks such as not diversified, price volatility, competitive industry pressure, international political and economic developments, possible trading halts, and index tracking errors. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk. Rebalancing a portfolio may cause investors to incur tax liabilities and/or transaction costs and does not assure a profit or protect against a loss. Investing involves risk including loss principal. This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.